CRAIN v. ELECTRONIC MEMORIES & MAGNETICS CORP. Docket No. 13966.
50 Cal.App.3d 509 (1975)
123 Cal. Rptr. 419
WILLIAM W. CRAIN et al., Plaintiffs and Appellants, v. ELECTRONIC MEMORIES AND MAGNETICS CORPORATION et al., Defendants and Respondents
Court of Appeals of California, Fourth District, Division Two.
August 6, 1975.
James C. Peterson for Plaintiffs and Appellants.
Eilers, Stewart, Pangman & Miller, Richard K. Quinn, Rutan & Tucker, John B. Hurlbut, Jr., C. Richard Lemon, Crosby & Luesebrink and Richard W. Luesebrink for Defendants and Respondents.
Plaintiffs (a class of founding shareholders represented by William W. Crain) appeal from a judgment on the pleadings entered in favor of defendants. The judgment — which resulted in the dismissal of
Preliminary to our discussion of this case, we should properly set forth applicable rules regarding the scope of our reviewing authority involving an appeal from a judgment on the pleadings.
Because of the aforestated rules, the appellate court must assume an unusual posture in reviewing judgments entered on the pleadings.
Between 1965 and 1968 the plaintiffs (a group of computer engineers, programmers, and data processing specialists), with the assistance of several independent computer operations consultants, expended $40,000 in the design and development of a prototype for the "Documentor
During the course of the next year it became obvious to the founding shareholders that DSC would require substantial amounts of new capital in order to meet payroll and operating expenses, as well as to finance plant and equipment investment, design, field testing, and marketing programs.
This financing arrangement was approved by DSC's founding shareholders at two meetings in late 1970. And on December 8, 1970, EMM had defendants Rosenberg and Taylor named to the DSC board of directors.
Also during 1970 EMM succeeded in securing the removal of DSC's chief executive officer (N. Robert Crain) and had him replaced with defendant Zechter, by threatening to discontinue its financing of the DSC venture. Zechter then succeeded to the DSC board of directors, and by year's end EMM representatives occupied a majority of the directors' chairs (three of five).
Between November 1969 and December 31, 1971, EMM advanced $3.5 million to DSC. These funds were invested, in part, in capital investment, development, and field testing of the Documentor accounting system. Defendant Zechter, as president of DSC, mailed the corporation's shareholders glowing financial reports during 1970 and 1971, predicting a bright future for the computer company. Zechter's last report to the shareholders was dated February 28, 1972. It read, in part, as follows: DSC sales figures had risen from $31,000 in 1970 to $519,000 in 1971 ($236,000 during the last quarter of 1971); research, development, and production costs had been "stable" for the past year; the Documentor system's reliability had been improved, and its unit cost reduced; new orders had been received from Gino's and MacDonald's fast-food chains; DSC customers were reportedly satisfied with the company's product; new distributorship agreements had been signed in
Although EMM had provided substantial capital to DSC during 1970-1971, EMM had suffered serious financial losses. In 1970, EMM showed operating losses of $14 million. In 1971, operating losses amounted to $8.5 million (on sales of $75 million), and investment losses (other than DSC) mounted to $7 million. As a result of these losses EMM's line of bank credit was reduced from $20 million to $9 million and, eventually (in September 1972) to $7 million. EMM's publicly traded common stock fell from $40.12 to $6.37 (per share) in 1970, and as a result the New York Stock Exchange suspended all credit purchases of EMM shares in May 1971.
Plaintiffs suggest that these financial reversals presented EMM with a serious cash-flow problem, and a search for liquid assets within the corporation was begun. At this same time defendants Rosenberg, Taylor, and Zechter (all intimately tied to the management of EMM), as directors of DSC, initiated a search for a purchaser of DSC assets.
On May 26, 1972, Zechter, as president of DSC and on behalf of the corporation, executed a purchase and sale agreement with defendant Addressograph Multigraph Corporation (AM) for the sale of the "entire business and assets" of DSC. Said agreement was ratified the same day by a majority of DSC's board of directors. (Three of the board's five directors approved the sale: defendants Rosenberg and Zechter, and Robert Crain.) By the terms of the agreement DSC was required to call a special meeting of its shareholders no later than June 15, 1972 to ratify the sale; and EMM agreed that it would exchange a sufficient number of its convertible notes to secure a majority (51 percent) of the outstanding shares of DSC prior to the June 15 meeting. Sometime between May 26 and June 15 EMM exchanged enough promissory notes to secure 1,302,458 shares of DSC stock — which represented 80 percent of the outstanding shares.
Pursuant to the purchase agreement AM was required to make an immediate cash payment of $981,200 to DSC (a total deferred payment of $1,056,200 was eventually to be paid); assume direct responsibility to repay EMM $453,103.94 — which represented the sum still owed to EMM on its unconverted promissory notes; assume all current liabilities and obligations of DSC; and pay EMM the sum of $20,000 for a covenant not to compete for three years. On June 15, immediately following shareholder approval of the sale, Zechter met with AM representatives to formally transfer the business and assets. Rosenberg, Taylor and Sprigle were also present and accepted the $981,200 cash payment on behalf of the corporation. Immediately upon receipt of this sum these three defendants loaned the entire amount to EMM, and took in return an unsecured promissory note payable to DSC. At the conclusion of the transfer Zechter received a long term employment contract (with a 60 percent increase in salary) to continue as chief executive officer of AM's new "documentor accounting systems" operation.
Subsequent to the formal transfer of assets, EMM made a private, restricted purchase offer to all DSC minority shareholders, other than the plaintiffs. As a result of this offer EMM was able to purchase all outstanding DSC shares, save for plaintiffs', for cash. Since June 15, 1972, DSC has existed as nothing more than a "shell" corporation, wholly inactive, whose only asset is an unsecured promissory note for some $981,200. DSC's three directors have announced that plaintiffs' shares, because of their promotional status, will henceforth be considered worthless by the corporation; and plaintiffs will be excluded from any and all future corporate distributions.
The plaintiffs' first cause of action names EMM, Rosenberg, Taylor and Zechter as defendants, and charges that each engaged in self-dealing transactions and otherwise breached fiduciary duties owed to plaintiffs as minority shareholders. Plaintiffs allege that EMM, as a majority shareholder acting through the aforenamed defendant-directors, conspired to dispose of DSC assets in such a way so as to insure that EMM received the largest possible financial benefit, without regard to the financial consequences visited upon the minority shareholders. The second cause of action names the same defendants aforementioned, and alleges that they engaged in constructive fraud and breached fiduciary duties by encouraging defendant Zechter to author deceptive and misleading shareholder reports, which concealed material information regarding DSC's financial condition, financing arrangements, and prospective sale of assets. Plaintiffs allege that Zechter's glowing stockholder reports of 1970 and 1971 were written at the behest of EMM, with the aid of the other defendants, and were overly optimistic — especially in light of EMM's precarious financial situation.
The third and fourth causes of action name EMM as the only defendant and are based upon alleged breaches of contract. In the third cause of action, plaintiffs assert that the DSC-EMM financing agreement of November 1970 included a provision which covenanted that, if EMM should convert a sufficient number of its promissory notes to become DSC's majority shareholder (on or before Dec. 28, 1974) it (EMM) would continue to advance necessary financing funds to DSC, and to
Plaintiffs' fifth cause of action names Rosenberg, Taylor, Sprigle, Zechter and AM as defendants and charges each with tortious interference with, and inducement of breach of, contract (e.g., the above-enumerated provisions of the DSC-EMM financing agreement). Plaintiffs assert that each of these defendants was aware of the aforementioned covenants which were designed to protect the minority shareholders' ownership interests in an ongoing concern, and that these defendants induced EMM to default on these promises.
Causes of action six through nine are really no more than prayers for relief, and do not allege facts which set forth independent causes of action. Number six requests exemplary damages from defendants EMM, Rosenberg, Taylor and Zechter for their fraudulent behavior in disposing of the DSC assets. The seventh cause (which names AM, EMM and 12621 Chadron Ave., Inc.) requests that the court declare that plaintiffs have a "continuing equity interest" in the former DSC assets, now the property of AM, since the sale of said assets was invalid inasmuch as director approval was not given by 80 percent of the DSC board (as provided for in the DSC-EMM "purchase agreement" portion of the 1970 financing agreement). The eighth cause of action requests that the court rescind the $981,200 loan to EMM, and prohibit further distribution of those proceeds pending the outcome of this lawsuit. And nine
After all defendants answered, counsel for defendants EMM, Taylor, Sprigle, Rosenberg and 12621 Chadron Ave., Inc., on January 7, 1974, moved for judgment on the pleadings, on the ground that the "causes of action set forth in plaintiffs' complaint fail to state" a legally cognizable claim. Defendants argued, in points and authorities in support of their motion, that plaintiffs' first (for breach of fiduciary duty and self dealing), second (for constructive fraud and breach of fiduciary duty), and eighth (a prayer to rescind the EMM loan and prohibit distribution of the DSC sale proceeds) causes of action, if injuries at all, are injuries to the corporation as a whole, and may not be sued upon by plaintiffs in their individual capacities; that plaintiffs' third (for breach of third party beneficiary contracts contained in the DSC-EMM financing agreement), fifth (for tortious inducement of breach of contract), and seventh (a request for declaratory relief to undo the sale of assets) causes of action are, again, injuries to all shareholders of DSC, and not to these plaintiffs personally and, hence, are derivative in nature; that the fourth cause of action (for failure to register DSC shares with the SEC, as covenanted) was prematurely brought; and that the sixth and ninth causes of action are prayers for relief only, and must be dismissed pursuant to the motion if the other seven causes are so dismissed.
Defendant AM filed a motion for judgment on the pleadings as well (also on Jan. 7) and argued that: (1) plaintiffs' fifth cause of action is exclusively derivative, and improperly pleaded herein as individual; and (2) plaintiffs' seventh cause of action gives rise to no cause of action against AM whatsoever (inasmuch as AM had nothing to do with the failure of the DSC board to obtain the approval of 80 percent of the directors) unless plaintiffs are seeking to rescind the entire transaction, in which case, they assert, the action for rescission cannot be characterized as anything but derivative.
On March 15, 1974, the trial court granted defendants' motion for judgment on the pleadings on the ground that the complaint set forth only derivative causes of action.
On August 5, 1974, plaintiffs filed a timely notice of appeal from the judgment.
Disposition of this case on review is controlled by Jones v. H.F. Ahmanson & Co.,
The high court noted that a breach of fiduciary duty by a majority shareholder does not necessarily give rise to either a corporate or derivative cause of action, but that the same operative facts may give rise to both causes of action simultaneously. The court concluded that a derivative action is proper where the injury alleged is one inflicted upon the corporate entity, or inflicted upon the "whole body of stock" of the corporation. (At p. 106.) The court compared this sort of action against one brought by a shareholder in his individual capacity — which must seek to enforce a right against the corporation which the shareholder possesses as an individual, and apart from the corporate entity: "The individual wrong necessary to support a suit by a shareholder need not be unique to that plaintiff. The same injury may affect a substantial number of shareholders. If the injury is not incidental to an injury to the corporation, an individual cause of action exists." (At p. 107.)
In Jones, the majority shareholder engaged in activities which increased the value of his shares at the expense of plaintiffs' minority shares — which were rendered valueless. In the instant case, defendants (EMM as majority shareholder and the other defendants as its agents) likewise engaged in self-enriching activities which impinged upon rights of the minority shareholders in two respects: (1) The defendants' acts deprived plaintiffs of their ownership interests in an ongoing and potentially profitable business without any compensation whatsoever; and (2) by "locking" plaintiffs into a "shell" corporation, which possesses no real assets nor engages in any kind of business activity, defendants insured that the minority's shares will forever be valueless and unsalable.
Further, plaintiffs' complaint sets forth a legally cognizable claim for which a remedy may be fashioned. The Jones court held that a majority shareholder may not use its power to control corporate activities for its benefit alone, or in a manner detrimental to the minority's interests. (At pp. 108-109.) Clearly, defendants' sale of the entire business and all the assets of DSC was seriously detrimental to the rights and interests of the class of promotional shareholders who are plaintiffs in this lawsuit. (See also Brown v. Halbert,
Lest defendants suggest that they were absolutely privileged to effectively dissolve DSC by selling its assets and business, in order to avoid serious financial losses (pursuant to Corp. Code, § 4600), it must be pointed out that the Supreme Court has held that the majority shareholders have no such unqualified right.
Plaintiffs' first, second and eighth causes of action (which allege individual actions for defendants' breach of fiduciary duties) adequately
Plaintiffs' third cause of action is set forth as one for breach of contract. The contract provisions allegedly breached provide that EMM shall, if it becomes a majority shareholder in DSC, continue to advance necessary working capital to the computer company, and will "use its best efforts to ... operate the Documentor Business ... as to maximize the benefits to the Shareholders." (Italics added.)
Likewise, plaintiffs' fourth cause of action sets forth third party beneficiary contract provisions which merely delineate defendants' common law fiduciary duty not to "lock" plaintiffs into ownership of valueless stock shares (perhaps in anticipation of a Jones v. Ahmanson problem, wherein the market trading for EMM shares could, if EMM obtained a large enough percentage of DSC's outstanding shares, drive the market value of DSC shares to zero).
Since plaintiffs' complaint contains facts which entitle them to individual — and not solely derivative — relief, the trial court was in error
Gardner, P.J., and Kaufman, J., concurred.
On August 22, 1975, the opinion was modified to read as printed above.
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