The opinion of the court was delivered by: BROTMAN
I. Procedural and Factual Background
Plaintiffs by their consolidated amended class action and derivative complaint, filed May 12, 1986, ("Complaint"), sued defendants, pursuant to their claim that defendants harmed plaintiffs by artificially inflating the price of ORFA common stock. Plaintiffs, individuals
and one corporate entity, ("Plaintiffs"), are shareholders of ORFA common stock who purchased such stock at various times during 1985 and 1986. As explained in Part IV-B of this opinion, the court finds that the class period for this action is April 1, 1985, to January 20, 1986, inclusive ("Class Period"). All the named plaintiffs are individuals residing in states other than New Jersey, except for derivative plaintiff, Looking Sharp, Inc., which is a corporation organized and operating from the state of Florida. Defendant ORFA Corporation, ("ORFA" or "Corporate Defendant"), is a corporation duly organized under the laws of the state of Utah with its principal executive offices in the state of New Jersey. ORFA's common stock is traded on the national over-the-counter market. ORFA is a development stage enterprise engaged in the marketing and developing of waste processing facilities utilizing a technology which employs a proprietary solid waste material recovery process that produces usable end products. Individual defendants ("Individual Defendants") are four officers of ORFA who served the corporation at some time during the Class Period. Each Individual Defendant owned between 10% and 15% of ORFA's outstanding common stock at some point during the Class Period. Individual Defendants Kaye and Kohn are residents of New Jersey. Individual Defendant Moore is a resident of Pennsylvania. Individual Defendant Hutchison's residence is in dispute. Plaintiff asserts Hutchison's residence is Texas and defendant asserts it is Switzerland.
The Complaint alleges five counts. Count I is brought pursuant to Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), ("Act"), and Rule 10b-5, 17 C.F.R. § 240.10b-5 (1986) ("10b-5"). Count II and Count III are brought pursuant to common law fraud and deceit and negligent misrepresentation. Count IV is brought pursuant to the Racketeer Influenced and Corrupt Organization Act, 18 U.S.C. § 1961 et seq. (1983) ("RICO"). Count V is brought as a derivative cause of action on behalf of ORFA against the Individual Defendants pursuant to the common law of fiduciary obligations. Plaintiffs seek damages and costs under all counts in addition to an accounting under Count V. Jurisdiction of this court over Count I and Count IV is pursuant to 15 U.S.C. § 78 aa and 18 U.S.C. § 1964(c), respectively. Jurisdiction of these claims being proper pursuant to 28 U.S.C. § 1331, the remaining common law claims, Counts II, III, and V,
are properly before the court pursuant to the principles pendent jurisdiction. Plaintiffs seek to certify this action as a class action pursuant to Fed. R. Civ. P. 23 with a class period extending from April 1, 1985, (the date of filing with the Securities and Exchange Commission of ORFA's Form 10-K for the year ended December 31, 1984), to January 31, 1986, (eleven days following the publication of the Barron's article disclosing the alleged misrepresentation and omissions of ORFA Corporation and its officers) ("Defendants"). Oral argument on Defendants' motion to dismiss Counts II, III, and V, of the Complaint was held on September 5, 1986. Oral argument on Plaintiffs' class certification motion was held on October 27, 1986. The court reserved opinion on both matters at the time of oral argument.
Presently before the court are three basic issues: (1) is there a cause of action under New Jersey common law for a derivative plaintiff seeking relief from individual corporate officers who trade individually owned corporate stock on the basis of insider information, (part II of this opinion)? (2) is the exercise of pendent jurisdiction over state law claims, Counts II and III brought as a class action, appropriate for this court, (part III of this opinion)? and (3) if class certification is appropriate, what is the proper class period, (part IV of this opinion)? The court finds that a claim by a derivative plaintiff against corporate officers trading individually owned shares on the basis of insider information does state a claim upon which relief can be granted. The court finds that the exercise of pendent jurisdiction over Counts II and III is proper. Therefore Defendants' motion to dismiss Counts II, III, and V, is denied. The court grants Plaintiffs' motion for class certification and finds the appropriate class period to be April 1, 1985, to January 20, 1986, inclusive.
The gravamen of Plaintiffs' Complaint is two-fold: (1) ORFA Corporation and its officers issued false and misleading statements about ORFA for the purpose of artificially inflating the price of ORFA common stock; and (2) Individual Defendants took advantage of information obtained as corporate officers and used it for personal advantage to the detriment of the corporation and its shareholders in selling individually owned shares. The alleged misrepresentations were contained in different reports or news releases of ORFA over a time period extending from December 31, 1984, to January 8, 1986. The cited reports include: (1) ORFA's Form 10-K, fiscal year ending December 31, 1984; (2) ORFA's 1984 Annual Report; (3) ORFA's Form 10-Q, for quarter ended June 30, 1985; (4) ORFA's Form 10-Q, for quarter ended September 30, 1985; and (5) ORFA's Form 8-K, December 3, 1985. The cited news releases include: (1) April 1985, as reported in the Wall Street Journal; (2) July, 1985 "Update;" (3) October, 1985, as reported in Forbes; and (4) January 8, 1986, as reported in the Philadelphia Inquirer. Plaintiffs' salient allegations of misrepresentation, Complaint at paras. 25-42, include misleading statements and omissions pertinent to (1) the status of ORFA's contractual negotiations for the construction of the ORFA process facilities, (2) the status of ORFA's state of the art technology; (3) the overall position of ORFA in the waste processing market; and (4) the status of ongoing construction projects. Plaintiffs allege that said misrepresentations concerning "the ORFA process and the future prospects of the Company," caused the value of ORFA stock to rise significantly and lead to increased trading during the Class Period. Defendants deny such allegations.
Plaintiffs further allege that named Individual Defendants sold amounts of their individually owned ORFA stock over a four-month period of October, 1985, to January, 1986, inclusive. See Complaint at para. 43. Defendants admit to selling shares of their individual holdings of ORFA common stock during this time, in the approximate percentage of their total holdings: Kohn, 4.4%; Kaye, 3.1%; Moore, 1.3%; and Hutchison, 2.4%. See Individual Defendants' Answer to Consolidated Amended Complaint para. 42. Plaintiffs allege that Individual Defendants took advantage of the inflated price of ORFA stock by selling individually held shares for personal gain prior to a January 20, 1986, Barron's article which disclosed certain information concerning the Defendants. Plaintiffs allege that the Barron's article entitled "A Touch of Alchemy? How to Turn Trash into $90 Million," revealed material misrepresentations and omissions made by Defendants.
It is undisputed that the value of ORFA stock dropped in the week after publication of the article. Plaintiffs allege a $2.25 drop per share in one week. Complaint at para. 44. The court reporter's stenographic record reflects that at oral argument on the class certification motion, Defendants asserted that the value of the stock dropped some 50% from Friday, January 20th, to Monday, January 23rd.
II. Derivative Action Based on Insider Trading
Count V of the Complaint seeks equitable and legal relief for Plaintiff Looking Sharp, Inc. derivatively on behalf of ORFA against Individual Defendants for violations of New Jersey common law. Specifically, Count V alleges that the Individual Defendants violated their fiduciary obligation to the corporation and its stockholders by using "material non-public insider information" for their own personal profit in deciding to sell their individually owned stock in ORFA. The count alleges substantial damage to ORFA resulted from Defendants' sale of stock. In addition the count alleges that a demand to the corporation to remedy these alleged wrongs would have been futile in that the Individual Defendants constituted a majority of the ORFA Board of Directors and therefore could not diligently prosecute this action because in effect that would require the Individual Defendants to prosecute themselves. Simply put, the count seeks to establish a common law right of action for a derivative plaintiff against a corporate officer who has traded stock of the corporation on the basis of inside information. Defendants seek to dismiss Count V, pursuant to Fed. R. Civ. P. 12(b)(6), for failure to state a cause of action upon which relief can be granted under New Jersey law.
All counsel acknowledge that this specific issue raised under New Jersey common law is an issue of first impression. This court is mindful of the limitations on a federal court sitting in diversity (the alleged basis of jurisdiction of Count V) on a question of state common law. In deciding whether such a new cause of action should be allowed, this court must confine itself to the developments of New Jersey law. See Novosel v. Nationwide Insurance Co., 721 F.2d 894, 897 (3d Cir. 1983) (citations omitted).
There is some dispute among the litigants as to how many other states have created or considered a common law derivative action on the basis of insider trading. It is clear that four states have squarely addressed the issue and others have discussed in dicta. Of the four states squarely addressing the issue, two, New York and Delaware, have created such a cause of action.
The New York case of Diamond v. Oreamuno, 24 N.Y.2d 494, 301 N.Y.S.2d 78, 248 N.E.2d 910 (1969), contains the fuller discussion of the two. Diamond relied on the Delaware case of Brophy v. Cities Service Co., 31 Del. Ch. 241, 70 A.2d 5 (1949), in establishing the cause of action. 24 N.Y.2d at 500, 301 N.Y.S.2d at 82. Diamond itself held that officers of a corporation breached their fiduciary duty to the corporation by trading in that corporation's stock on the basis of material non-public information accessible to them as a result of their position with the corporation, 24 N.Y.2d at 502-03, 301 N.Y.S.2d at 84-85. The Diamond court explicitly refused to condition the claim on a showing of harm to the corporation. 24 N.Y.2d at 499, 301 N.Y.S.2d at 81. However, the court did suggest that an inference of harm to the company's reputation and capability of management, could easily be made where "officers and directors abuse their position in order to gain personal profits." 24 N.Y.2d at 499, 301 N.Y.S.2d at 82.
Defendants in the case at bar argue that the Diamond rational is based exclusively in the court's view that remedies for shareholders suing directors for insider trading were inadequate at the time, 1969. Brief of Individual Defendants To Dismiss at 10. A full reading of Diamond shows that the decision was grounded both in that court's interpretation of the laws of fiduciary obligations and the need for effective remedies. The court found that one "who is entrusted with potentially valuable information, may not appropriate that asset for his own use. . . ." 24 N.Y.2d at 499, 301 N.Y.S.2d at 81; see also 24 N.Y.2d at 497, 301 N.Y.S.2d at 80 (A fiduciary "is not free to exploit that knowledge or information for his own personal benefit.") (citing New York law and 100 A.L.R. 680). In addition to the court's view that such behavior by directors violated their fiduciary duty, the court found that such directors could be held to account for any profits derived from the behavior.
In short, the Diamond court grounded the cause of action in its view that a director who profits from his use of information obtained as a result of his fiduciary capacity has been unjustly enriched. 24 N.Y.2d at 501, 301 N.Y.S.2d at 84. The court found articulation of this principle at various sources, see Brophy ; Securities Exchange Act of 1934, § 16(b), 15 U.S.C. § 78p(b); Restatement Second, Agency § 388 comment (c), and deemed the alleged wrongdoing an appropriate subject for the application of common law fiduciary obligations, 24 N.Y.2d at 504, 301 N.Y.S.2d at 86. The court also addressed the need to deter such behavior, 24 N.Y.2d at 499, 503, 301 N.Y.S.2d at 81, 85, and create effective remedies for fiduciary breach by a director, 24 N.Y.2d at 502-03, 301 N.Y.S.2d at 84-85.
Since Diamond, two courts have explicitly rejected creating a Diamond-type cause of action. These include the Florida Supreme Court and the Seventh Circuit Court of Appeals applying Indiana law. The Florida case, Schein v. Chasen, reached the Florida courts by way of the state certification procedure. 478 F.2d 817 (2d Cir. 1973) vacated and remanded sub nom. Lehman Brothers v. Schein, 416 U.S. 386, 40 L. Ed. 2d 215, 94 S. Ct. 1741 (1974) on certification to Fla. Sup. Ct., 313 So. 2d 739 (Fla. 1975). The Florida Court refused to create the Diamond-type cause of action noting that state precedent required "actual damage" to the corporation be alleged. 313 So. 2d at 76. The Seventh Circuit Court of Appeals, applying Indiana law, came to a similar result, finding as a matter of law that under the Diamond-type cause of action "there is no injury to the corporation which can serve as a basis for recognizing a right of recovery in favor of the latter." Freeman v. Decio, 584 F.2d 186, 192 (7th Cir. 1978). The Freeman court reasoned that the unfairness of insider trading was borne primarily by traders not the corporation itself. Id. at 194. The court found the harm to the corporation to be too speculative and too indirect to support a derivative cause of action. Id. In rejecting the Diamond court's view, the Freeman court also found that since the time of Diamond, "the 10b-5 class action has made substantial advances toward becoming the effective remedy for insider trading that the court of appeals hoped that it might become." Id. at 195.
Since the Diamond case was decided, only Schein and Freeman have decided the issue presented by the case at bar. Other courts have noted in dicta the existence of a common law derivative claim based on insider trading under New York law, but have not reached a decision on whether or not to apply the law in their respective jurisdictions. See Fausett v. American Resources Management Corp., 542 F. Supp. 1234, 1240 (D. Utah 1982); Ferris v. Polycast Technology Corp., 180 Conn. 199, 206, 429 A.2d 850, 853 (1980); Katz Corp. v. T.H. Canty & Co., 168 Conn. 201, 210-11, 362 A.2d 975, 980 (1975).
The question of whether a derivative claim on the basis of insider trading states a cause of action under New Jersey law appears to be a question of first impression. For the reasons stated below this court finds that the derivative action states a claim upon which relief can be granted. Therefore Defendants' motion to dismiss Count V of the Complaint is denied.
As an initial matter, the court finds that New Jersey law is applicable to the question at issue. New Jersey conflicts of law questions are resolved under the "interest analysis" which weighs the interests and contacts of the states involved. Henry v. Richardson-Merrell Inc., 508 F.2d 28 (3d Cir. 1975). The New Jersey rules require the application of the law of the state with the most significant contacts to the dispute. Baron & Co., Inc. v. Bank of New Jersey, 504 F. Supp. 1199, 1204 (D.N.J. 1981). Under New Jersey law, the choice of law rules determining questions of a corporate officer's duties are typically determined by the law of the state of incorporation, "'except where, the respect to the particular issue, some other state has a more significant relationship.'" Francis v. United Jersey Bank, 162 N.J. Super. 355, 368-69, 392 A.2d 1233, 1240 (1978) aff'd 87 N.J. 15, 27-28, 432 A.2d 814, 820 (1981) (quoting Restatement (Second) of Conflicts § 309 (1971)).
It is undisputed that ORFA although incorporated in Utah has its principal place of business in New Jersey. Many of the acts complained of which formed the gravamen of this Complaint took place in New Jersey and none took place in Utah. Under the above noted conflicts rules, it is clear that New Jersey law applies to the questions raised by Count V of the Complaint.
2. Common Law of Fiduciary Obligations
Under New Jersey common law there can be no doubt that corporate officers have a fiduciary duty to both the corporation and its shareholders. Hill Dredging Corp. v. Risley, 18 N.J. 501, 530, 114 A.2d 697, 712 (1955); Daloisio v. Peninsula Land Co., 43 N.J. Super. 79, 88, 127 A.2d 885, 890 (1956). This duty demands the "utmost fidelity" and "absolute good faith" on the part of a corporate officer in all dealings with the corporation. Daloisio, 43 N.J. Super. at 88, 90, 127 A.2d at 890, 892; see also Judson v. Peoples Bank and Trust Co., 25 N.J. 17, 28, 134 A.2d 761, 767 (1957); Papalexiou v. Tower West Condominium, 167 N.J. Super. 516, 527, 401 A.2d 280, 286 (1979).
To say that the corporate director owes a fiduciary duty to the corporation does not end the inquiry; it merely begins it. As the Supreme Court pointed out in the related context of construing the Public Utility Holding Company Act of 1935, 15 U.S.C. § 79, one must go on to define the duty.
S.E.C. v. Chenery Corp., 318 U.S. 80, 85-86, 87 L. Ed. 626, 63 S. Ct. 454 (1943).
This court finds a foundation in New Jersey law for the proposition that a corporate director may not exploit inside information for personal gain. Judson, 25 N.J. at 29, 134 A.2d at 767; Hill, 18 N.J. at 531, 114 A.2d at 712. Under New Jersey common law this proposition ...