Cramer v. General Telephone & Electronics
443 F.Supp. 516, 1977 U.S. Dist. LEXIS 14374 (1977)
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Rule of Law:
A prior shareholder derivative suit precludes subsequent derivative actions under the doctrine of res judicata if they involve the same parties (the corporation being the real party in interest) and the same cause of action, or claims that could have been litigated. Furthermore, a Section 10(b) claim under the Securities Exchange Act of 1934 requires specific allegations of scienter (intent to deceive, manipulate, or defraud) and actual loss to the corporation from transactions "in connection with" the purchase or sale of securities, distinguishing it from Section 14(a) claims focused on misleading proxy solicitations.
Facts:
- Between January 1, 1971, and December 31, 1975, GTE's Board of Directors authorized an Audit Committee, composed solely of outside, non-management directors, to investigate whether GTE or any of its international subsidiaries had made illegal political contributions, unlawful payments to domestic or foreign government officials, or other improper or improperly recorded payments.
- The Audit Committee, assisted by the law firm Wilmer, Cutler and Pickering and the accounting firm Arthur Andersen & Co., conducted an investigation.
- The fifty-one page Audit Committee report, dated March 4, 1976, revealed approximately $8,000,000 in illegal payments made to or for the benefit of government officials as commercial kickbacks, rebates, or bribes to officials of private foreign customers.
- An additional sum, approximately $2,000,000, was paid pursuant to a pre-January 1, 1971, commission arrangement made between GTE officials and officers of a single foreign company, where GTE had sold a substantial ownership interest to foreign nationals and financed part of the purchase price by paying commissions on equipment sales.
- The entire Audit Committee report was included in GTE's 1976 Proxy Statement, distributed to all GTE shareholders, and both the original and a Supplemental Report were filed with the SEC.
- GTE's Board of Directors formed a Special Litigation Committee, composed of three independent directors with no prior connection to GTE, to assess GTE’s position with respect to these actions.
- The Special Litigation Committee concluded that the defendants (GTE corporate officials) had satisfied their responsibilities under state law, that the derivative actions were without merit, and that it would not be in GTE's best interests for any of the suits to be pursued by either GTE or the named litigants.
- The GTE 1975 Annual Report indicated that GTE offered 6,000,000 shares for public sale and issued 504,935 shares for exchange purposes in 1974, and purchased 4,775 of its own shares in 1974.
Procedural Posture:
- Mr. Auerbach, a GTE shareholder, filed a derivative action against GTE corporate officials and Arthur Andersen in the Supreme Court of New York in Westchester County on March 16, 1976, alleging waste of assets and breach of fiduciary duty.
- Two weeks after the Auerbach suit was filed, Mr. Limmer filed a derivative suit in the United States District Court for the Southern District of New York against corporate officials (Warner, Brophy, Douglas, Bennett), charging violations of Sections 13(a) and 14(a) of the 1934 Securities and Exchange Act and breach of fiduciary duty.
- On June 18, 1976, Harold Cramer commenced the instant shareholder derivative action in the United States District Court for the Eastern District of Pennsylvania against GTE corporate officers and Arthur Andersen & Co., alleging violations of Sections 10(b), 12(b)(1), 13(a), and 14(a) of the 1934 Act, as well as breach of fiduciary duties.
- The Supreme Court of New York dismissed the Auerbach complaint on April 29, 1977.
- The U.S. District Court for the Southern District of New York dismissed the Limmer complaint on March 11, 1977; the Section 13 claim was voluntarily withdrawn by the plaintiff and dismissed with prejudice, and the Section 14(a) claim was dismissed for failure to state a claim.
- Defendants in the Cramer case filed a joint motion to dismiss the complaint for failure to state a claim under Fed.R.Civ.P. 12(b)(6), or alternatively, for summary judgment on grounds of res judicata and collateral estoppel.
- Plaintiff Cramer filed a motion for a Protective Order under Rule 26(c) of the Federal Rules of Civil Procedure.
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Issue:
1. Does the doctrine of res judicata bar a shareholder derivative action's claims under Sections 13(a) and 14(a) of the 1934 Securities and Exchange Act and pendent state law claims, where similar claims arising from the same facts were previously dismissed in other derivative suits? 2. Does a shareholder derivative complaint state a claim under Section 10(b) and Rule 10b-5 if it alleges corporate mismanagement and non-disclosure of illegal payments without specifically alleging that the defendants acted with intent to defraud the corporation in connection with the purchase or sale of securities, and without alleging damages to the corporation? 3. Does a shareholder derivative complaint state a claim under Section 12(b)(1) without alleging that the corporation purchased or sold a security in reliance upon false filings, that the price was affected, and that there was a causal nexus to the alleged loss?
Opinions:
Majority - Higginbotham, District Judge
Yes, the claims under Sections 13(a), 14(a), and the pendent state law claims are barred by res judicata. However, the claims under Sections 10(b) and 12(b)(1) are not barred by res judicata from prior litigation but are dismissed on alternative grounds for failure to state a claim. Regarding Sections 13(a) and 14(a), the court found that the Limmer suit involved the same parties as Cramer. In derivative actions, the corporation (GTE) is the real party in interest, making the shareholder plaintiffs merely nominal. The operative facts in both cases were identical, arising out of the transactions reported by the Audit Committee. The Limmer court specifically dismissed the Section 14(a) claim for failure to state a claim, concluding that the alleged damages flowed from a breach of fiduciary duty rather than from any shareholder vote obtained by misleading proxy solicitation, as required for a Section 14(a) claim. The Section 13(a) claim in Limmer was voluntarily withdrawn and dismissed with prejudice. Therefore, res judicata bars Cramer’s claims under both Sections 13(a) and 14(a). Regarding Sections 10(b) and 12(b)(1), the court held that res judicata did not apply based on the Limmer decision. Section 10(b) and Section 14(a) are not identical causes of action because they require different elements, particularly concerning the "purchase or sale of any security" and the element of scienter for Section 10(b). A finding of no Section 14(a) violation does not automatically lead to a finding of no Section 10(b) violation, as highlighted by Lawlor v. National Screen Service Corp. which cautions against binding parties on issues not fully litigated in connection with another cause of action. However, the court dismissed the Section 10(b) claim on alternative grounds, finding a failure to state a claim under Rule 12(b)(6). While GTE had standing as a purchaser or seller of securities through issuing its own shares, purchasing its own shares, and selling a subsidiary interest, Cramer failed to allege the crucial element of scienter. As established in Ernst & Ernst v. Hochfelder, Section 10(b) requires "a mental state embracing intent to deceive, manipulate or defraud." The complaint alleged corporate mismanagement and failure to disclose, but it was devoid of any allegation that the defendants intended to defraud GTE. Furthermore, Cramer failed to allege that GTE suffered any loss from the purported manipulative devices "in connection with" the purchase or sale of securities. Corporate mismanagement, even if ethically questionable, does not automatically constitute fraud under Section 10(b) without the requisite intent and direct connection to securities transactions. The Section 12(b)(1) claim was also dismissed for failure to meet the standing requirements of Section 18. Section 18 limits standing to plaintiffs who purchased or sold a security in reliance upon false or misleading information filed under Section 12 or 13, whose purchase or sales price was affected by such information, and who lacked knowledge of the omissions or misrepresentations. Cramer's complaint contained none of these essential allegations, nor was a causal nexus made between any filing and any alleged loss GTE suffered. Finally, the pendent state law claims were barred by res judicata due to the Auerbach v. Bennett judgment in New York state court. That court found no breach of fiduciary duty by the defendants and upheld GTE's decision not to pursue legal action under the business judgment rule. The state judgment was a valid final judgment involving the same parties and cause of action. As an alternative reason, the court declined to exercise pendent jurisdiction over the state claims once all federal claims were dismissed, following United Mineworkers of America v. Gibbs.
Analysis:
This case clarifies the application of res judicata in the context of successive shareholder derivative actions, emphasizing that the corporation, not the individual shareholder, is the true party in interest. It distinguishes between different sections of the Securities Exchange Act, particularly reaffirming that a Section 10(b) claim mandates allegations of scienter and a direct causal link between the fraudulent act and a securities transaction, preventing plaintiffs from repackaging general corporate mismanagement as federal securities fraud. The decision sets a high bar for pleading specific elements for each claim, reinforcing that mere allegations of ethical failings or negligence are insufficient without meeting statutory and jurisprudential requirements. This ruling limits the avenues for shareholders to challenge corporate actions under federal securities laws, funneling general mismanagement claims to state corporate law, while ensuring only actual securities fraud claims proceed federally.
