Kalodner, Ganey and Seitz, Circuit Judges.
One of several plaintiffs ("plaintiff") in a stockholder's derivative action on behalf of Hydromatics, Inc. ("Hydromatics"), a New Jersey corporation, appeals from the judgment entered by the district court after a lengthy final hearing before the court. The defendant directors ("defendants") and Hydromatics also appeal.
Plaintiffs below asserted claims against the defendants under the New Jersey common law and under the Securities Exchange Act of 1934 as amended (15 U.S.C.A. § 78aa). Each claim is based on alleged wrongful acts of the defendants in connection with the sale of 64,534 additional shares of Hydromatics stock to themselves and to outsiders (who were not sued) in private placement transactions at a price so far below the contemporaneous fair value for the shares as to amount to fraud. The district court denied relief on the common law claim and granted partial monetary relief on the federal claim. See Pappas v. Moss, 257 F. Supp. 345 (D.N.J. 1966). On appeal plaintiff seeks additional relief on the federal claim and full relief under the common law cause. By their appeal defendants seek to be absolved of any liability. The other issues raised by the various parties need not be resolved at this time in view of our conclusions with respect to the principal claims of the parties.
Prior to the issuance of the shares here involved, Hydromatics, Inc. had 500,000 authorized shares of common stock of which some 288,000 shares were issued and outstanding, plus 30,000 shares reserved for issuance under a stock option plan. In 1960 all of these shares were listed for trading on the American Stock Exchange.
At all times here pertinent the defendants constituted the board of directors of Hydromatics and all except one were officers thereof. The one non-officer director was also named as a defendant in his capacity as trustee of the Company's Profit-Sharing and Retirement Trust. Prior to the stock sale in dispute, the defendants owned in the aggregate 170,957 shares. In addition, the trustee of the Profit Sharing Trust held 1,100 shares. Thus, the individual defendants controlled 172,057 out of a total of 288,000 outstanding shares.
By resolution dated December 21, 1961, the defendants by board action unanimously authorized the issuance of up to 100,000 shares of Hydromatics common stock at a price of $6.00 per share to themselves and to a limited number of additional purchasers. The purchasers agreed to hold the shares for investment purposes only, but it was provided that the corporation would cause such shares to be registered within eighteen months following the date of issuance. In the period between December 28, 1961, and January 3, 1962, the sales under attack were consummated. Thereafter this action was filed. Still later the stockholders were asked to ratify the sales under attack, although the directors' resolution did not require stockholder action. This course was apparently taken solely because the American Stock Exchange had indicated that such a vote would be considered in determining whether it would authorize the listing of such shares. The stockholders voted to ratify the sale. We turn to the grounds of appeal.
The district court decided that plaintiffs below had the burden of proving fraud in order to succeed on the common law claim and found that they failed so to do. Plaintiff here contends that the district court committed error in placing the burden on plaintiffs and in ruling that the issue was one of fraud.
Plaintiff does not challenge the general power of a board of directors of a New Jersey corporation to authorize, without stockholder approval, the sale of its authorized and unissued shares to non-directors. Plaintiff does challenge the power of a board to authorize the sale of such stock to its members without stockholder approval. We think a board of directors has the power to authorize a sale of its stock to one of its members, without stockholder approval, where, as here, its Certificate of Incorporation contains a provision permitting transactions between "interested" directors and their board.*fn1 We further conclude, but not without some concern, that under New Jersey law, at least where there is a provision in the Certificate of the type here described, the directors have the power to sell stock to themselves without stockholder approval even though all members are purchasers. In such a situation, however, the burden is on the interested directors to show by clear and convincing proof that the transaction was honest, fair and reasonable. Contrary to the implication in the district court's opinion, we think this burden was not shifted because of the Certificate provision in question. The very nature of the transaction here is such that it calls for pervasive scrutiny. Under less compelling facts the New Jersey Supreme Court in Abeles v. Adams Engineering Co., Inc., 35 N.J. 411, 173 A.2d 246 (1961), adopted the approach we have here taken.
It follows in our view, that unless there was effective stockholder ratification of the stock sales here involved, the defendant directors were required to shoulder the burden we have described.*fn2
We come to the crucial issue as to whether there was an effective ratification by the stockholders. We think the controlling law on this point is clearly stated in the opinion of the Supreme Court of New Jersey in Brundage v. New Jersey Zinc Co., 48 N.J. 450, 226 A.2d 585 (1967). Although that case involved the fairness of the terms of a merger, we think it is applicable, a fortiori, to our situation. The New Jersey court decided that where, as here, a majority of shares are held by those "interested" in effectuating the merger, there can be no ratification, at least in the sense that it transfers to the attacking party the burden of showing fraud. And this was the holding even though a substantial majority of the shares held by independent minority stockholders were voted in favor of ratification.
There having been no effective ratification, the stock sales must be evaluated as though there had been no stockholder action. In that posture, the New Jersey law, as we find it, required the defendants to establish by clear and convincing proof that the transaction was honest, fair and reasonable. Because it erroneously determined that there had been an effective ratification, the district court did not evaluate the evidence in the light of the correct legal principle. To the extent, therefore, that the judgment below dismissed the common law claim it must be reversed and the matter remanded for a determination based on the principles here announced. Compare Abeles v. Adams Engineering Co., Inc., above; Brundage v. New Jersey Zinc Co., above.
We next consider plaintiff's federal claims against the defendants. The first is based on their alleged violation of Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C.A. § 78j(b) and its implementing Rule 10b-5 (17 C.F.R. 240.10b-5), which provides:
"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 ...