Before BIGGS, Chief Judge, and STALEY and HASTIE, Circuit Judges.
The question presented by these appeals is whether a shareholder who brings a derivative suit to enforce a corporate cause of action arising under Section 10(b), 15 U.S.C.A. § 78j(b), as implemented by Securities and Exchange Commission Rule 10b-5, and Section 29(b) of the Securities Exchange Act of 1934, 15 U.S.C.A. § 78cc, may be required to post security for costs, including reasonable attorney's fees.
The plaintiffs hold as joint tenants 100 shares*fn1 of stock of the defendant, Borne Chemical Company, Inc., a New Jersey corporation having its principal office in New Jersey. The defendants are the Borne Chemical Company, Inc., its officers and directors, and CEM Securities Corporation, a Delaware corporation. The action is alleged to have been brought by the plaintiffs "on behalf of themselves in their individual capacities as stockholders," as a "spurious class suit" on behalf of themselves and others similarly situated, and also "to enforce their derivative or secondary rights as stockholders" of Borne. It is alleged that the defendants violated Rule 10b-5 in connection with the sale by Borne to CEM of 10,000 shares of the company's authorized but unissued capital stock. The complaint alleges that the plaintiffs were fraudulently deprived of their pre-emptive rights with respect to the 10,000 shares and that the shares were sold at an improperly low price, and that the defendants engaged in certain manipulative practices affecting the market price of the shares. It is further asserted that the acts complained of were done in furtherance of a conspiracy between the officers and directors of Borne, the majority stockholders of Borne, CEM, and CEM's controlling stockholder. The complaint sets forth various activities alleged to be breaches of fiduciary duties by the defendants which in turn constituted violations of Rule 10b-5. The plaintiffs stipulated in the court below "that the causes of action * * * are all based upon violations of Rule X-10B-5"*fn2 by the defendants, with Section 29(b) of the Securities Exchange Act of 1934 providing a supporting basis for a cause of action by reason of the violations of Rule 10b-5. The plaintiffs claim "no other cause of action in this litigation against these defendants". Injunctive relief, an accounting and rescission of the sale of stock by Borne to CEM, and other extensive relief are prayed for.
The defendants did not file an answer but moved to require plaintiffs to post security for expenses including reasonable attorneys' fees. In their motion the defendants asserted a right to security for expenses and counsel fees under the Pennsylvania Act of April 18, 1945, P.L. 253, No. 114, § 2, 12 Pa.Stat. § 1322, under Section 11(e) of the Securities Act of 1933, as amended, 15 U.S.C.A. § 77k(e), "as well as under equitable principles and rules." The court below denied the motion on condition that the plaintiffs file a statement limiting their claims to causes of action arising under Rule 10b-5 and Section 29(b). The plaintiffs did file such a statement which was accepted by the court below and the defendants have appealed.
The defendants make three arguments in support of their contention that a plaintiff who brings an action arising under Sections 10(b) and 29(b) of the Securities Exchange Act of 1934, 15 U.S.C.A. §§ 78j, 77cc, may be required to post security for expenses including reasonable attorneys' fees. These three arguments seek to overcome the fact that no provision of Section 10(b), Rule 10b-5 or Section 29(b) explicitly authorizes a court to require such security. First, it is contended that state law determines whether a plaintiff may be required to post security and that since both Pennsylvania, the State in which the court below sits and New Jersey, the State of incorporation and principal place of business of Borne Chemical Company, have security-for-expenses statutes, the defendants are entitled to the posting of security. Second, it is argued that under "general federal equity law" plaintiffs such as those at bar who bring derivative suits may be required to post security for expenses and that, therefore, even if state law be inapplicable the defendants are entitled to security. Third, the defendants assert that a security for expenses provision should be implied from Section 10(b) of the Securities Exchange Act of 1934 by analogy to other provisions of the Securities Acts which couple security for expenses provisions with provisions granting private rights of action. These arguments frame the three basic questions which must be considered. Preliminary to dealing with these questions, however, it is necessary to discuss the origin and nature of security for expenses statutes so that some of the fundamental considerations leading to our decision may be made plain.
Historically, the derivative suit has been the principal defense of the minority shareholder against abuses by the majority. In this era of the widening gulf between corporate control and corporate ownership, such suits have often served the further purpose of protecting the stockholders of a corporation against management which is sometimes unrepresentative and on occasion insufficiently concerned with the minorities' interests. Often where the wrongdoing is on the part of corporate officers and directors management has refused to act and where the wrongdoers control the corporation there is but small chance that the corporation itself will bring suit or vigorously prosecute the litigation. Equity, therefore, provided shareholders with the device of a derivative suit by means of which they could assert the interest of their corporation against management and third parties when those in control of the corporation were acting in breach of their trust.
There were, of course, obvious dangers of abuse inherent in a device that allowed an individual member of an association, whose interest might be very small, to bring a suit on behalf of the entire association. Consequently, equity itself imposed many limitations on the use of the derivative suit designed to prevent its use as a means to usurp the power of management, of the majority, or to turn the suit to private advantage. For example, equity imposed the requirements of exhaustion of intracorporate remedies,*fn3 of contemporaneous ownership,*fn4 and also defined an area of managerial discretion by developing the so-called "business judgment rule."*fn5 Despite these safeguards and others, however, there were many who felt that the abuses of the derivative suit as it had developed outweighed its utility as a tool by which corporate democracy and fiduciary duties could be enforced. Certain stockholders, it was observed, would sue the management in behalf of the corporation with no thought of gaining a corporate recovery but solely in the hope that management would "buy them off" by entering into a secret settlement with them. Some suitors gained financial advantages only by virtue of their nuisance value without having ever had a bona fide claim on behalf of the corporation. Moreover, it was vehemently suspected that many derivative suits were brought in the interest of attorneys seeking fees to be paid from the corporate treasury rather than by their clients who were often shareholders having so small an interest in the corporation as to render their ostensible concern for its welfare almost incredible.
In 1944 the Legislature of the State of New York enacted Section 61-b of the New York General Corporation Law, McKinney's Consol.Laws, c. 23, the first state security for expenses provision.*fn6 The law was based on a report made by Franklin S. Wood for a committee of the New York State Chamber of Commerce which contained an analysis of approximately 1300 derivative suits brought in the New York courts between 1932 and 1942 and which concluded that the equitable device was being abused. See Wood, Survey and Report Regarding Stockholders Derivative Suits (1944). Similar statutes were adopted in Maryland,*fn7 New Jersey*fn8 and Pennsylvania*fn9 in 1945. Subsequently, California*fn10 and Wisconsin*fn11 adopted security for expenses statutes that vary substantially from the New York model. The majority of state legislatures have not enacted such legislation.
Generally a security for expense statute provides that shareholders with relatively small holdings may be required, by their corporation, to post bond for reasonable expenses including counsel fees which may be incurred, either directly or indirectly, by the corporation as a condition precedent to maintaining or recovering in a derivative suit. The theory is that the derivative suit is most abused by shareholder-plaintiffs who have relatively minor financial interests in the corporation. State legislatures have differed in their conceptions of what constitutes a minor financial interest for the purposes of these statutes. The New York and New Jersey statutes provide that security may be required of any derivative plaintiff who holds less than 5% of the aggregate par or stated capital value of all the outstanding shares of the corporation unless the market value of his shares is in excess of $50,000. Pennsylvania requires that the plaintiff have a 5% interest in the corporation regardless of the market value of his shares. Thus, the Pennsylvania statute brings many more shareholders of widely held corporations within its scope while often making it easier for shareholders of closely held corporations to bring suit. In California security may be required only upon a showing by the party moving for security that there is no reasonable probability that the suit will benefit the corporation or that the moving party did not participate in the transaction complained of. Moreover, under the California statute, not only the corporation but also other defendants in a derivative suit may require a plaintiff to post security.
From their inception security for expenses statutes have been the subject of heated controversy. Governor Thomas E. Dewey of New York in supporting the New York provision and its correlative contemporaneous ownership statute, stated in a memorandum accompanying the two bills: "These two bills represent an effort to meet the problem created by the baseless so-called 'strike' stockholder suit against corporation directors and officers. In recent years a veritable racket of baseless lawsuits accompanied by many unethical practices has grown up in this field. Worse yet, many suits that were well based have been brought, not in the interest of the corporation or of its stockholders, but in order to obtain money for particular individuals who had no interest in the corporation or in its stockholders. Secret settlements - really pay-offs for silence - have been the subjects of common suspicion. * * * These bills represent a healthy experiment in cleansing our law courts of disreputable practices. * * *" The opposite view is well exemplified by the following passage from Hornstein, New Aspects of Stockholders' Derivative Suits, 47 Colum.L.Rev. 1, 3, 5 (1947): "The New York state legislation, since aped in other commercial states, was clearly designed to insulate corporate management from investors who discovered that the corporation had been looted. Had the legislators really been concerned with the so-called 'abuse' of stockholders' suits, the extortionate secret settlement, the remedy was painfully obvious: to bar secret settlements. This patent solution, twice recommended by the Law Revision Commission, was studiously avoided by the legislators. Instead, they adopted a series of laws of which not one was sponsored or recommended by the Law Revision Commission or the Judicial Council. The most drastic of these laws bars suits unless almost prohibitive conditions are met, * * * Meanwhile, the effective bar to suits, which the sponsors of the law hoped would result, has in fact resulted. In the two and a half years since enactment of the law, there appear to have been started in the Supreme Court, New York County, only four stockholders' suits involving widelyheld corporations, three of which have been dismissed for non-compliance with the new laws. These four suits amounted to less than two a year, as contasted with an annual average of over fifty a year in the preceding decade." For similar views see House, Stockholders' Suits and the Coudert-Mitchell Laws, 20 N.Y.U.L.Q. 377 (1945); Hornstein, The Death Knell of Stockholders' Derivative Suits in New York, 32 Calif.L.Rev. 123 (1944); Ballantine, Corporations, § 157(a) (rev. ed. 1946). We note that there is one proposition about which there is no controversy. A security for expenses statute poses a very serious obstacle to those shareholders to whom it applies who desire to maintain derivative suits.
The Inapplicability of State Security for Expenses Statutes in Derivative Suits brought to enforce Rights arising under Sections 10(b) and 29(b) of the Securities Exchange Act of 1934.
The Pennsylvania security for costs statute is clearly inapplicable even though this action was commenced in a federal court sitting in that State. In Erie R.R. v. Tompkins, 1938, 304 U.S. 64, 58 S. Ct. 817, 82 L. Ed. 1188, it was held that the substantive rules of the state in which a federal court sits are the rules of decision applicable in diversity actions brought in that court. That security for expenses statutes are "substantive" law as that term was used in the Erie decision was decided in Cohen v. Beneficial Indus. Loan Corp., 1949, 337 U.S. 541, 69 S. Ct. 1221, 93 L. Ed. 1528. In the present case, however, we are not concerned with a cause of action in which federal jurisdiction depends on diversity of citizenship, but with a case arising under a federal statute which itself confers jurisdiction upon the federal district courts. See ...