Arnold v. Searing

78 A. 762, 78 N.J. Eq. 146, 8 Buchanan 146, 1910 N.J. Ch. LEXIS 4

Opinion

Howell, V. C.

In order to determine whether the defendants are or are not to be characterized as promoters, it is sufficient to carefully consider what they did in connection with the enterprise now under examination. They undertook to transform the securities of the rolling mill company from a stock issue to a stock and bond issue, to increase these securities from $200,000 to $1,500,000, without the addition of a dollar to the assets of the company, and to make a nearly complete change in the personnel of the real owners of the property. To effectuate this result they decided by agreement between 'themselves upon all of the details of the plan, and calculated the amount of profit which they would make out of the transaction, and ascertained and set down in writing each man’s share thereof long before they made any portion of the scheme public; they organized a sjmdicate which was to furnish all the funds necessary to carry out the scheme, the members of which were to be stockholders and bondholders of the new company, and practically made Mr. Bell sole manager by providing that the trust company, of which he was president, should be sole manager. They were the incorporators of the new company, which was provided for in their scheme, and they became the first stockholders and directors thereof, although they paid nothing for the stock which gave them control of its management, and they executed the amended certificate of incorporation to make the charter conform to the plan which they had settled upon weeks before. They caused themselves to be elected stockholders and directors of the rolling mill company, and as stockholders and directors oí the two companies they joined in the execution of the merger agreement which contained the final formulation of their plan. They, with the possible exception of Mr. Bell, busied themselves for a long period in procuring syndicate subscribers, and to some extent at least used their personal influence to procure subscriptions. By the fifth paragraph of the syndicate agreement they reserved to themselves the right to-abandon the whole enterprise if they saw fit. In short, they originated the plan and carried it out. Whatever was done was done by them with the aid of Lazelle and the finance company. Without the defendants the scheme would not have been conceived and could not have been carried through. These facts, in my opinion, put the defendants upon the footing of promoters of the. steel company and subjected them to all the liabilities and responsibilities which that important function casts upon them under the rules of law. Woodbury Heights Land Co. v. Loudenslager, 55 N. J. Eq. (10 Dick.) 78; affirmed, 58 N. J. Eq. (13 Dick.) 556; Plaquemines Tropical Fruit Co. v. Buck, 52 N. J. Eq. (7 Dick.) 219; Dickerman v. Northern Trust Co., 176 U. S. 181; Pittsburgh Mining Co. v. Spooner, 74 Wis. 307.

It will be observed that a promoter, when he shall have been,, found to be such as a matter of fact, is a sort of self-constituted agency for bringing a company into existence, and this fact alone-would go far toward charging him as a fiduciary. He has in his-hands the creation and molding of the company; he has the poAver of defining how and when and in what shape and under what .supervision it shall start into existence and begin to act as a trading corporation. It is he Avho selects the directors,-to whom he gives such poAArer as he chooses; it is he who settles the regulations of the company, regulations under which the company, as soon as it comes into existence, may find itself bound to anything not in itself illegal, which the promoter may have chosen. This control of the promoter OArer the company, so plenary and absolute, involves a correlative responsibility, and out of this responsibility arises the doctrine now well settled of the fiduciary relation of the promoter toward the company he creates. This fiduciary relationship of the promoter is an extension of the doctrine of agency, a sort of agency by anticipation, for the promoter is not, strictly speaking, an agent of or trustee for the company before incorjioration, but it is a salutary and necessary fiction of equity for the protection of the company. In virtue of this fiduciary relationship the promoter is accountable to the company for all moneys secretly obtained by him from it. Secrecy is the gist of the wrong. The law does not say a promoter may not make a profit out of a company he promotes, provided he makes a full and fair disclosure to the company of what he is getting, and the company assents to it.

As promoters it was their duty to provide an independent and impartial board of directors (Plaquemines Tropical Fruit Co. v. Buck, 52 N. J. Eq. (7 Dick.) 219), and to disclose to the persons who were about to become shareholders what profit, if any, they were to make out of the transaction. It is universally held that promoters of a corporation have no right to make secret profits. See v. Heppenheimer, 69 N. J. Eq. (3 Robb.) 72; Groel v. United Electric Company of New Jersey, 70 N. J. Eq. (4 Robb.) 622; Bigelow v. Old Dominion Copper Co., 74 N. J. Eq. (4 Buch.) 496; Old Dominion Copper Co. v. Bigelow, 203 Mass. 159. By secret profits is meant such profits as are made by the promoter without disclosing the same to the real parties in interest and obtaining their consent, either express or implied.

In this case the promoters did make a profit of about $100,000 in bonds and $3,000,000 in stock. That is to say, in the manipulation of the property, and the securities representing it, they were enabled to withdraw from the company twenty per cent, of its bond issue and sixty per cent, of its stock issue, for which they paid nothing, and for which they rendered no service, except such service-as was necessary to put through the operation by virtue of which they were enabled to make the profit. They claim that at the time this was done, to wit, on February 16th, 1903, everybody in interest consented thereto, and that therefore there can be no liability. To this, however, there are two answers. In the first place, the company cannot be held to have consented, for the reason that the promoters did not provide it with an independent board of directors who might look after its interests, but, on the contrary thereof, they placed themselves in the dual position of directors whose duty it was to watch over the affairs of the corporation, and promoters who had an interest only in obtaining the largest prossible profit from the operation.

Lord O’Hagan, in New Sombrero Phosphate Co. v. Erlanger, 3 A. C. 1218; 48 L. J. Ch. 73, speaking of directors so appointed and selected, says: “If the directors were nominated merely to ratify any terms the promoters might dictate, they discharged their functions. If it was their duty, as it certainly was, to protect the shareholders, they never seem to have thought of doing it; their conduct was precisely that which might have been anticipated from the character of their selection, and, taking that conduct and character together, I concur in, I believe, the unanimous opinion of your lordships, that such a transaction cannot be allowed to stand. The promoters who so forgot their duty to the company they formed as to give it a directorate without independence of position, or vigilance or caution in caring for its interests, which were accordingly subordinated to their own, misused their power and must take the consequences.” In the second place, the real parties in interest, as opposed to the interests of the promoters, were the syndicate shareholders who had furnished or had agreed to furnish the actual cash with which the promoters’ operation was carried on; they were not notified in any manner of the amount that the promoters were expecting to make. They severally became equitable stockholders in the new corporation, as soon as they had subscribed to the syndicate shares, and it had been determined that the operation would be carried on; they were, with the promoters, the equitable owners of the stock, and-as such were entitled to be informed by the promoters of all details of the operation and of the amount of profit which they were making. Vice-Chancellor Learning so held when this case was before him on demurrer to the bill that was originally filed. Arnold v. Searing, 73 N. J. Eq. (3 Buch.) 262.

On the same point the present chancellor says, in the Bigelow Case, 74 N. J. Eq. (4 Buch.) 457: “In many cases promoters in anticipation of the formation of the company themselves buy property in order to make it over to the company upon formation. Whether the company in such eases is entitled to claim the benefit of the bargain made by the promoter is often a question of nicety, and may depend upon whether the promoter buys the property •with, his own money or with money that is in effect subscribed for the share capital. It may be thus in effect subscribed before the formation of the company, as is the case with many syndicates, in which event the promoter may be a trustee with respect to the property for the company thereafter to be formed, on the theory that the property was bought for the company.”

This remark applies with peculiar force to the case in hand. When the promoters took the options for the purchase of the-rolling mill company’s stock they did it with the idea of investing' the new company with the title to the property which the stock represented, and at once made themselves to a certain extent trustees for the syndicate shareholders who furnished the funds-for carrying out the plan. It therefore becomes evident that it was the duty of the promoters to make full disclosure to the syndicate subscribers of all the profit which they intended to make.

It was said on behalf of the defendants that full disclosure of all the facts was made in the circular which accompanied the syndicate agreement of August 2d, 1902, because it was possible-for anyone to calculate from the data given that after the syndicate subscribers had been satisfied there would be left $400,000' in bonds and $3,000,000 worth of stock which must have been understood to belong to the promoters. It is quite true that such a calculation would show such a result, but it is not true that there-is anything in the circular or in the agreement which would indicate in the slightest degree that this surplus was intended as promotion fees or that the defendants had any interest whatever in-it. This point was touched upon in Re Olympia, Limited, L. R. 1898; 2 C. D. 153; 67 L. J. Ch. 433. Lindley, M. R., says:“The main question which has to be determined in this case is-whether the documents to which I have referred contain a sufficient disclosure of that which it was the duty of the promoters to disclose to the company, and to those who were invited to join it. In considering this question we must recollect that we are dealing-with matters of daily business and must have regard to the habits and practical necessities of ordinary business men. Refined equitable doctrines of constructive notice have little, if any, application to such matters as are now being dealt with. To inform a person of a fact is one thing; to give him the means of finding- it out, if he will take- trouble enough, is another thing. A promoter of a company whose duty it is to disclose what-profits he has made does not perform that duty by making a statement not disclosing the facts but containing something which, if followed tip by further investigation, will enable the inquirer to ascertain that profits have been made, and what they amounted to.”

I must therefore conclude that the profits made by the promoters in this case were not disclosed to either the corporation or to its real stockholders, and that they are liable to account for the same in an equity suit brought for the purpose.

The next question relates to the form of the suit. The bill, as amended, is filed by three stockholders of the new company against the three defendants. The corporation itself is likewise a party defendant. The company became insolvent and its receivers were added to the suit as parties complainant. Therefore, as the bill now stands, it is a bill filed by stockholders and by the receivers of the insolvent corporation, in which they attempt to enforce a cause of action which they claim runs to the corporation. In other words, they are prosecuting in the right of the corporation. The defendants assert that the cause of action does not run in favor of the corporation, and that it, as a legal entity, has no interest in the transaction, and that taking the charge against the defendants at its utmost weight the corporation itself has no right or interest in the transaction to be protected. The complainants’ theory is that the defendants, while they were holding a fiduciary relationship toward the steel company, took and assisted others to take bonds of the corporation without consideration, whereby the indebtedness of the company was increased $400,000. and took $3,-000,000 of the stock of tire corporation, all without the knowledge of the company or the syndicate shareholders, and that the defendants should pay the value of the bonds and stock so taken, and that in this view the right of action accrues in favor of the corporation. The point appears to have been decided adversely to the complainants’ view by the supreme court of the United States in Old Dominion Copper Mining Co. v. Lewisohn, 210 U. S. 206. That was a bill in equity brought by the corporation to rescind a. sale to it of certain mining rights and lands conveyed to the corporation by the defendants’ testator, or in the alternative to re cover damages for the sale, and it was held that inasmuch as at the time of the sale the promoters and the promotion syndicate were on both sides of the bargain, everybody who then had an interest must be held to have consented to what was done, therefore the corporation consented, and therefore it could not after-wards complain; and that as to those stockholders who purchased stock directly from the company later on, their cause of action for the fraud which was committed upon them was a personal one in which the corporation had no interest. The cases which approve of this ruling are collected in the opinion of Mr. Justice Cornish, of the Maine supreme court, in Mason v. Carrothers, 74 Atl. Rep. 1030. If, however, the defendants are promoters, and by means of their machinations the corporation has been fraudulently deprived of a portion of its property, it would seem as if the cause of action for the recovery of the property is a cause of action in favor of the corporation. In Plaquemines Tropical Fruit Co. v. Buck, supra, the bill was filed in favor of the corporation, praying that its promoters might be compelled to surrender for cancellation some shares of its capital stock alleged to have been improperly issued to and’ held by them as such promoters, and to restrain them from voting thereon. It does not appear that any question was raised as to the right of the complainant corporation to sue; that seems to have been taken for granted. At any rate, the form of the action was acquiesced in and the decree on the motion was in the company’s favor. The same course was pursued in Woodbury Heights Land Co. v. Loudenslager, supra. There the bill was filed by the corporation against the defendant, who was held to be a promoter, for an account and recovery of profits realized by him in the promotion. The decree required him to account to the corporation for the amount of profits that was actually received by him. I take it the doctrine contended for by the complainants on this branch of the case is settled in this state in favor of the corporation. The point is expressly held in Massachusetts in favor of the complainants’ view in Hayward v. Lesson, 176 Mass. 310. There a bill was filed by the receiver of the East Tennessee Land Company to recover alleged secret profits made by the defendants as promoters of that corporation. Mr. Justice Loring says “that the corporation may sue for the secret profits made by a promoter who secures a sale of lands from-a third person to the corporation without returning the lands obtained by means thereof, is well settled. Emery v. Parrott, 107 Mass. 95; Lydney and Wigpool Iron Ore Co. v. Bird, 33 C. D. 85; Emma Silver Mining Co. v. Lewis, 4 C. P. D. 396,” and the proceedings were amended by substituting the corporation in the place of the receiver as party complainant. This practice was followed in the same court in Old Dominion Copper Mining and Smelting Co. v. Bigelow, 188 Mass. 315, and in England in New Sombrero Phosphate Co. v. Erlanger, 5 C. D. 73; 46 L. J. Ch. 425; affirmed in house of lords, 3 A. C. 1218; 48 L. J. Ch. 73 and in Re Leeds and Hanley Theatres (1902), 2 Ch. 809; 72 L. J. Ch. 1.

The lord-chancellor, in the house of lords, in the Erlanger Case, calls special attention to the fact that the suit is in favor of the corporation. The decree eventually was in its favor. It was indeed admitted by one of the defendants in this case that the rule that the corporation might recover had been adopted in New Jersey. I must therefore say that the suit in its present shape is properly brought. It may be that when the moneys are recovered equities will arise on the distribution which will require solution, but we need' not concern ourselves with that question at the present time.

The last question involves the principles upon which recovery may be had. It would not be just or reasonable to charge any of the defendants with the par value of the share capital taken by them, for the reason that all the syndicate subscribers who became shareholders in the new company considered the stock to have no actual value, and that it was purely and simply a bonus in which all the stockholders participated. The shareholders who are complainants in this suit received their shares upon this basis. As syndicate subscribers they were entitled to bonds- at ninety-five per cent. 'This amount they put in in cash and the stock was a mere gratuity. All the stock stands on this footing. The complainants and the company are thus estopped from asserting the invalidity of the stock, and inasmuch as there do not appear to be any creditors, the receivers are estopped also. 2 Cl. & M. Corp. § 398; Knoop v. Bohmrich, 49 N. J. Eq. (4 Dick.) 82; 50 N. J. Eq. (5 Dick.) 485; Breslin v. Fries-Breslin Co., 70 N. J. Law (41 Vr.) 274. I therefore think that there should be no accounting for any of the stock profits which were made by the promoters.

The defendants Fairchild and Searing are undoubtedly liable, jointly and severally, for all the profits made by the promoters, in so far as that profit consisted of bonds of the corporation, and were it not for the view which the court of errors and appeals took of the defendant's liability in the Loudenslager Case, I would think that Mr. Bell might, on principles of equity, be charged equally with them. I must adopt Chancellor Pitney's interpretation of the Loudenslager Case in his opinion in the Bigelow Gase, supra, and charge Mr. Bell only with the amount of profit that was received by him. There is some justice in the application of the rule in the Loudenslager Case to the case of Mr. Bell, for the reason that he stands somewhat apart from the other two defendants in his attitude toward the promotion scheme and in his-, relation to the transaction. As I have elsewhere said, he seems to-have done little, if anything, more than he would have been required to do as president of the trust company; he was made a participant in the profits'principally to reimburse him for extra, labor and effort to which he would be put in that capacity.

It appears that many months after this transaction was entirely completed the company came into financial difficulties, and that in order to save it from insolvency, Mr. Bell and other stockholders and bondholders surrendered to the company a large amount, of stock and bonds to aid it in its financial distress. It was claimed on the part of Mr. Bell that in any accounting to which he might be subjected, he should be credited with the amount of stock and bonds which he so surrendered. My view of the relation of the stock to the whole enterprise hereinabove stated would preclude any credit to Mr. Bell on this account. I reach the same conclusion as to the bonds surrendered by him, but for an entirely different reason. He is called upon to account for what he received at the time he received it, and he is chargeable as of the-time when the bonds were issued to him. If he saw fit afterwards to give the bonds back or to employ them in some other manner-for the advantage of a sinking company, he cannot have credit therefor without the consent of the parties interested. There is-. no claim that at the time the bonds were donated by him to the company or used by him for its bénefit the company released him from liability or accepted the bonds on account of his indebtedness or did otherwise than to take them as his free gift. Hence there can be no set oif, either legal or equitable. This is made still more manifest when we consider the intervention of the receivers. Williams v. Traphagen, 38 N. J. Eq. (11 Stew.) 57; McManus-Kelly Co. v. Pope Manufacturing Co., 70 Atl. Rep. 297.

I will therefore advise a decree against Mr. Fairchild and Mr. Searing, jointly and severally, for the full amount of the promoters’ profits, and against Mr. Bell in the same manner, but only to the extent to which he profited by the transaction. If the amounts cannot be agreed upon by counsel there will be a reference to ascertain the same.