APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF NEW JERSEY (D.C. Civil No. 623-69).
Van Dusen, Rosenn and Weis, Circuit Judges.
The sale of stock in a closely held corporation, induced by misrepresentation and nondisclosure of material information, is the basis of this 10b-5 suit. We conclude that inaccurate statements about the lack of improvement in the financial health of the corporation and failure to reveal nascent negotiations for acquisition establish liability. However, a damage award which amounts to an overly generous windfall must be remanded for further consideration.
In 1949, plaintiff Morton Thomas and defendant Bertram Lesser formed the Duralite Corporation to manufacture light weight aluminum furniture. Each party owned 50 percent of the company stock. In time, the company expanded and moved its operations from New York to a site in New Jersey which it rented from the Randolph Avenue Corporation, a company owned by Thomas and Lesser and created for the sole purpose of holding the real estate.
For many years the two men had a very close and cordial working relationship. They shared office space as well as management responsibilities. Generally, Thomas was more concerned with production problems while Lesser took it upon himself to oversee the financial aspects of the corporation. In 1958, they made the other individual defendant, Irving Zakin, responsible for the company's sales operations and at a later date gave him some stock in both Duralite and Randolph.
In 1964, Duralite suffered a loss of $600,000.00 which led to a deterioration of the close relationship between Thomas and the defendants. A contest for presidency of the corporation resulted, and in 1965 Thomas withdrew from all management functions of the corporation.
At that point Thomas and Lesser each owned 45 1/2 percent of the Duralite stock and each owned 45 percent of the Randolph shares. Lesser offered to buy out Thomas' stock in both Duralite and Randolph in 1965 but the proposal was not accepted.
Thomas then formed Temco Products, Inc., a company which utilized aluminum tubing in its products. Later, he became associated with a Donald Edwards who owned the Edco Surgical Supply Company, and by 1967 Thomas and Edwards each owned 50 percent of the stock of Edco and Temco.
In late 1967, Thomas agreed to accept $112,500.00*fn1 for his Duralite stock. The proposed contract between Thomas and Duralite made the sale contingent upon the consent of certain creditors of Duralite who held various security interests. Because of Duralite's weak financial condition, however, the creditors refused to approve the purchase of Thomas' stock.
In January, 1968, Lesser and Thomas met to discuss sale of his Randolph stock. Lesser disclosed that Duralite had a net loss for fiscal 1967 of $409,000.00, and conveyed the clear impression to Thomas that his stock in Duralite had no value but, rather, represented only a negative equity. The import of Lesser's conversation was that there was substantial doubt that Duralite could continue in business. He produced a written appraisal of Thomas' interest in Randolph which discounted the value because of "possible inability to sell within one year," "reduced value in event of distress sale," and "possible foreclosure if mortgage payments are not kept current." The real estate which formed the sole asset of Randolph was valued at $800,000.00, and Thomas' stock was appraised at $71,600.00. The fortunes of Randolph were necessarily dependent upon Duralite because that company was the sole tenant and source of income.
During the meeting, Thomas indicated that he would consider a transfer of his Duralite stock in exchange for cancellation of his loan and of Edco's indebtedness. A few weeks thereafter, Thomas' accountant verified the $409,000.00 loss but evaluated Thomas' interest in Randolph at $91,272.00.
At about this same time, and unknown to Thomas, several discussions took place between the defendant Zakin and James H. Kaltsas, the president of Prest-Wheel Company, also a manufacturer of porch furniture. Although nothing definite was proposed, there were some vague allusions to a possible merger between Prest-Wheel and Duralite.
At a subsequent meeting in early April, 1968, Lesser gave Thomas the impression that Duralite was faced with imminent disaster. In response to Thomas' question about the company's progress, Lesser responded vaguely, but in substance, that the situation had not changed. In fact, it had improved and ultimately Duralite would have a profitable year. Lesser remarked that he was staying with Duralite only for the salary and hoping that somebody might find some interest in the company. Lesser carefully did not disturb Thomas' impression that the stock was worthless.
The contract for the sale of Thomas' interests in Duralite and Randolph to the latter company was finally completed and signed on June 18, 1968. Soon afterwards, Lesser transferred some of his stock so that Zakin would own one-third of the outstanding shares in both Duralite and Randolph and Lesser would own two-thirds. The conversations between Zakin and Kaltsas still had not been disclosed to Thomas.
A few days after the signing of the Thomas contract, Zakin and Kaltsas discussed a possible merger with Giffen Industries. Kaltsas stated that he was confident Giffen would want Duralite. Zakin then telephoned Lesser and told him about the merger possibility.
On November 21, 1968, the transfer of the plaintiff Thomas' stock was completed. The total consideration was $109,892.81.
On December 5, 1968, Kaltsas brought an official of Giffen Industries to New York where they joined Zakin and then met with Lesser in New Jersey. After less than two hours of negotiations, the parties agreed that all of the Duralite stock held by Lesser and Zakin would be exchanged for 16,667 shares of Giffen. At that time Giffen stock was selling at $60.00 in the over-the-counter market. On the following day, the official of Giffen met again with Lesser and agreed to exchange an additional 16,667 shares for the stock in the Randolph Corporation.
A letter agreement of January 8, 1969 provided for the acquisition of all the shares of Duralite and Randolph by Giffen and for five-year employment agreements with Lesser and Zakin at salaries of $40,000.00 per year. Within the next few weeks, the price of Giffen stock fell from $60.00 to $40.00. To meet this change in value, an agreement of February 28, 1969 increased the number of Giffen lettered shares giving Lesser 30,000 and Zakin 15,000 shares.
At the closing transaction on March 31, 1969, Lesser and Zakin delivered all of their Duralite stock.*fn2 Giffen was not required to produce its shares then since the agreement provided that the company was to use its best efforts to register the stock before December 31, 1969 and then turn over the certificates to Lesser and Zakin. In the interim, they continued to work for Duralite which had become a wholly-owned Giffen subsidiary.
Upon discovery of this chain of events, Thomas filed suit for damages on June 2, 1969, alleging that he was induced to sell his shares of Duralite and Randolph for $109,892.81 at a time when they had a value in excess of $1,000,000.00. Edco and Temco joined in the suit as plaintiffs, alleging that their agreement to purchase certain material from Duralite was void as a result of the fraudulent stock transaction.
Giffen's fortunes continued to ebb and, by the end of 1969, it was unable to transfer the 45,000 shares of registered stock as required. Lesser and Zakin then sought to rescind the agreement.
According to Giffen's chairman, Duralite had proved to be profitable, and Lesser and Zakin had become very valuable to the company. On April 17, 1970, after a series of negotiations, a new agreement was reached between Giffen and the defendants. As a result, the Randolph real estate was conveyed to Lesser and Zakin, the property being subject to a long-term lease to Duralite, and in November of 1970, the two men received $600,000.00 in cash and notes. The employment contracts were amended to increase the defendants' salaries from the $40,000.00 originally agreed upon to $55,000.00, retroactive to January 1, 1970.
The suit in the district court alleged violations of §§ 10(b), 20 and 29(b) of the Securities Exchange Act of 1934, 15 U.S.C.§§ 78j, 78t, and 78cc(b), and Rule 10b-5. A pendent claim asserting fraud under New Jersey law was included in the complaint. Defendant Duralite filed counterclaims against Edco and Temco for the value of products delivered to them and for certain inventory items which they had ordered but later refused to accept.
After a lengthy non-jury trial, the district court accepted the plaintiff's contention that the defendant Lesser had misrepresented a critical fact with intent to deceive Thomas. Lesser was found to have spoken falsely in April of 1968 in describing a loss situation in Duralite and the worthlessness of its stock. The court considered defendant's silence between that time and June 18, 1968, when the contract of sale was signed, to be an affirmation that nothing had changed.
Damages were awarded to the plaintiffs and against Lesser and Zakin in the sum of $821,148.15, representing the difference between what Thomas received for his stock in 1968 and the amount which Lesser and Zakin received in 1970 when the new arrangement was negotiated. Prejudgment interest was also included. Since the court believed that Duralite had not shared in the "windfall" profits of the 1970 transactions, a judgment against it was limited to $131,257.19 (the difference in value of Thomas' stock on November 21, 1968 and what he actually was paid), plus interest from that date, for a total of $178,164.55. Liability over for that amount was entered against Lesser and Zakin.
Judgment was entered in favor of Duralite on its first counterclaim for goods delivered to Edco and Temco in the amount of $17,175.88. The second counterclaim for goods ordered but not delivered was dismissed with prejudice.
We affirm the finding of liability against Lesser and Zakin, but reverse as to Duralite and remand for further consideration of damages.
Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), prohibits the use of fraudulent schemes in connection with the purchase or sale of securities. Rule 10b-5 of the Securities and Exchange Commission, enacted to implement the statutory purposes, reads:
"It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances ...