Caseflicks

Court of Appeals for the Seventh Circuit • 1987

James S. Jordan, Cross-Appellee v. Duff and Phelps, Inc., Claire v. Hansen, and Francis E. Jeffries, Defendants- Cross-Appellants

815 F.2d 429

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Takeaway

In short, this case holds that a closely held corporation buying an employee-shareholder's stock may have to confidentially disclose material sale negotiations, even when the employee's sale is triggered by leaving the firm; disputed materiality, timing, scienter, causation, and damages require trial, though rescission is unavailable once employment cannot be restored.

Background

Duff & Phelps was a closely held financial-services company whose employee-shareholders were required to sell their stock back to the company at adjusted book value when their employment ended. James Jordan, a securities analyst, owned 188 shares and held rights to purchase 62 more. He resigned in November 1983 to take a better-paying job in Houston, principally because of family pressures in Chicago. By agreement, he stayed through the end of December so his shares would be valued as of December 31, 1983. He surrendered the stock on December 30 and was sent $23,225, its book value.

Unknown to Jordan, Duff & Phelps had earlier discussed a $50 million acquisition with Security Pacific, and its board had authorized efforts to find a buyer shortly before Jordan resigned. Negotiations with Security Pacific resumed in December. On January 10, 1984, the companies announced an agreement in principle. The transaction later failed because of conditions imposed by the Federal Reserve, but Duff & Phelps completed an employee-stock-ownership transaction in late 1985 that Jordan alleged valued his former shares far above book value.

Jordan sued under Rule 10b-5, initially seeking damages and later seeking rescission. The district court granted summary judgment for the defendants. It held that merger negotiations did not become material or disclosable until the parties reached an agreement in principle approved by their boards, and that Jordan could obtain neither rescission nor damages because the Security Pacific transaction failed. Jordan appealed, and Duff & Phelps cross-appealed on the issue of rescission.

Issues

Issue #1

Whether a closely held corporation must disclose material merger-related information when buying a shareholder's stock even though the prospective acquirer is a public corporation.

Holding

Yes. The disclosure rule for closely held corporations, rather than the public-company price-and-structure rule, governs Duff & Phelps's repurchase of Jordan's shares.

Reasoning

Under Michaels v. Michaels, a closely held corporation purchasing its own shares must disclose material information to the selling shareholder. Materiality is governed by the TSC Industries standard: whether there is a substantial likelihood that a reasonable investor would consider the omitted information important and would view it as significantly altering the total mix of available information.

The public-company rule allowing secrecy until agreement on price and structure rests on the concern that disclosure to one public shareholder effectively discloses the negotiations to the market, potentially disrupting the deal and reducing value for investors as a whole. That concern does not control where a closely held corporation can confidentially inform only the shareholder from whom it is buying stock.

Security Pacific's status as a public company did not change the analysis. Duff & Phelps could have told Jordan about its decision to seek a buyer and the status of negotiations without publicly revealing Security Pacific's plans or alerting rival bidders. Thus, the district court erred by applying the public-company price-and-structure rule simply because one party to the proposed acquisition was publicly traded.

Issue #2

Whether the undisclosed information was material, and whether the relevant sale date was Jordan's November resignation or his December delivery of the shares.

Holding

Those questions could not be resolved for the defendants on summary judgment; they must be determined by a jury.

Reasoning

A jury could find material the information available when Jordan resigned: Duff & Phelps's November 14 decision to seek bids for the company, combined with Security Pacific's earlier willingness to value it at $50 million. That information could have materially affected a reasonable shareholder's decision whether to remain employed and retain the stock.

A jury could also find that the sale occurred on December 30 rather than November 16. The company valued Jordan's shares as of December 31, 1983, rather than using the prior year's book value that would have applied had the sale been fixed at his November resignation. Jordan also offered evidence that employees could withdraw resignations and that he might have remained employed through year-end.

If December 30 was the sale date, the withheld information was material as a matter of law. By then the negotiating teams had worked out the price and structure of the Security Pacific transaction, even though the boards had not yet formally approved it.

Issue #3

Whether Duff & Phelps owed Jordan a duty to disclose despite the stock-repurchase agreement, the formula book-value price, and Jordan's status as an at-will employee.

Holding

Yes, at least on the record at summary judgment. The agreement did not eliminate the closely held corporation's fiduciary duty to disclose material facts in connection with its repurchase of Jordan's stock.

Reasoning

Rule 10b-5 does not generally require parties to disclose valuable private information. But silence becomes actionable when a duty to disclose exists. Here, that duty arose from the fiduciary obligations of a closely held corporation purchasing shares from one of its shareholders, the duty recognized in Michaels and earlier insider-trading cases involving face-to-face transactions.

Parties may sometimes contract around disclosure obligations by making information irrelevant to a transaction, such as through a formula-price sale on a fixed and unavoidable date. But Jordan's agreement set the price upon termination; it did not fix the date of termination or require him to decide whether to leave without regard to the stock's value.

Jordan's decision was both an employment decision and an investment decision. He could choose when to trigger the repurchase obligation, and the evidence suggested that Duff & Phelps allowed employees to time departures to obtain a more favorable book-value date. The company itself allowed Jordan to remain through year-end for that purpose.

At-will employment did not establish that Duff & Phelps could opportunistically fire Jordan solely to capture for the remaining shareholders the value of an imminent merger. An at-will relationship remains contractual, and the court reasoned that even such a relationship includes an implied constraint against avowedly opportunistic conduct. The defendants themselves had not argued that they could have defeated Jordan's claim merely by firing him before a merger.

Whether Duff & Phelps acted with the scienter required for a Rule 10b-5 violation remained open. Because the defendants did not seek summary judgment on scienter, and because intent depends on the parties' expectations and conduct, that question also remained for trial.

Issue #4

Whether Jordan could obtain rescission of the stock sale.

Holding

No. Rescission was unavailable because the parties could not be restored to their pre-transaction positions.

Reasoning

Rescission ordinarily unwinds a transaction and returns each party to the position occupied before it occurred. Jordan's ownership of Duff & Phelps stock was tied to his employment, but he had left the company, moved to Houston, and did not offer to return to work.

Because the court could not restore Jordan's employment for the intervening years, undoing the stock sale would not truly restore the prior arrangement. Jordan therefore could pursue damages, rather than rescission, if he proved a securities-law violation.

Issue #5

Whether the failure of the Security Pacific merger eliminated Jordan's damages as a matter of law, and how causation and damages should be addressed on remand.

Holding

No. The failed merger did not establish an absence of damages, and causation and the proper damages measure presented factual and remedial questions for further proceedings.

Reasoning

The materiality and value of omitted information are assessed when the securities transaction occurs, not solely by hindsight. Security Pacific's willingness to pay $50 million in an arm's-length transaction was evidence that Duff & Phelps had value materially above its $2.5 million book value, even though regulatory conditions later ended that particular deal.

The later employee-stock-ownership transaction, which valued the company at roughly $40 million, further undermined the conclusion that Jordan's shares were worth only book value. The collapse of one proposed sale for regulatory reasons did not prove that no other buyer would pay a premium for the company.

Jordan nevertheless had to prove causation: that full disclosure would have led him to remain at Duff & Phelps and retain the shares long enough to benefit from a later premium transaction. A jury could find that he would have stayed, because a reasonable investor could view the board's decision to sell the company and Security Pacific's interest as reasons to wait despite the family and employment pressures that prompted his move.

The court identified possible damages approaches without prescribing one. Market damages could compare the book-value price Jordan received with the fully informed expected value of the shares as of the sale date. Rescissionary damages could measure the gain retained by the other shareholders. In this transaction, those measures might substantially overlap because Duff & Phelps's repurchase increased the remaining shareholders' portion of the firm's eventual value.

Any calculation must account for uncertainty about whether a sale would occur, the difference between Jordan's Chicago and Houston compensation, and whether Jordan would have remained employed. The district court was directed to address those matters on remand rather than treating damages as unavailable as a matter of law.

Concurrences

Judge Cudahy

Reasoning

Judge Cudahy joined the majority's disposition and agreed that Michaels, not the price-and-structure rule, controlled the repurchase of stock in this closely held company. He regarded a remand for trial as the more defensible result under the circumstances.

He wrote separately to reserve judgment on whether the price-and-structure rule should govern mergers involving public companies. In his view, neither this case nor Flamm was an appropriate vehicle for deciding that broader question, particularly because the Securities and Exchange Commission's substantial opposition to the rule had not been fully examined.

Dissents

Judge Posner

Reasoning

Judge Posner would have affirmed because he believed Duff & Phelps had no duty to disclose its prospective sale to Jordan. Rule 10b-5 makes silence actionable only where a duty to speak exists, and he concluded that the parties' actual agreements, not a generalized fiduciary principle, defined whether such a duty existed.

Jordan was an at-will employee, and his stock agreement required the company to repurchase his shares at book value whenever his employment ended, whether he resigned, was fired, retired, or died. The agreement also expressly stated that stock ownership gave him no right to continued employment. In Judge Posner's view, these provisions gave Duff & Phelps an effective option to end Jordan's shareholder status at the formula price.

Because the company could have accepted Jordan's resignation immediately, or could have discharged him before any merger, disclosure would not have given Jordan a legally enforceable opportunity to profit from the information. Judge Posner therefore reasoned that a supposed duty to provide information that Jordan had no contractual right to use was empty and inconsistent with the parties' bargain.

He distinguished Michaels because the employee-shareholder there could retain his shares after employment ended. He also maintained that fiduciary duties in closely held corporations must be shaped case by case, rather than imposed automatically whenever the corporation buys a shareholder's stock.

Judge Posner rejected the majority's reliance on an implied prohibition against opportunistic discharge. In his view, Illinois at-will employment law generally permits termination for any reason or no reason, absent a violation of clearly established public policy. The stockholder agreement expressly preserved that at-will relationship instead of creating an implied promise that Jordan could remain employed to capture unexpected appreciation.

He further questioned the majority's treatment of causation and damages. Whether Jordan would have stayed depended on personal and practical factors beyond the company's expected value, including his family situation, risk preferences, higher Houston salary, Hansen's willingness to let him withdraw his resignation, and Jordan's likely response when the Security Pacific deal later failed. An investment bank's valuation could inform the inquiry but could not substitute for proof that disclosure would have changed Jordan's conduct.