Johnson v. Trueblood

629 F.2d 287, 29 Fed. R. Serv. 2d 1267

• Court: Court of Appeals for the Third Circuit
• Decided: July 31, 1980
• Docket: No. 79-1892
• Status: Published

Opinions

OPINION OF THE COURT

SEITZ, Chief Judge.

The plaintiffs, Gilbert and Hervey Johnson, appeal from a judgment for the defendants, majority shareholders and directors of Penn Eastern Development Co., in this diversity suit charging the defendants with fraud and breach of fiduciary duty under Delaware law.

I.

The present controversy centers on the conduct of the affairs of Penn Eastern, incorporated in June 1968 as a real estate development company. The plaintiffs, Gilbert and Hervey Johnson, owned a 47 percent interest in Penn Eastern. The defendants, Samuel and Arnold Trueblood and Harry Salwen, collectively owned the controlling 53 percent interest. At its inception, a major asset of Penn Eastern was land known as the “Red Caboose” property owned by the Truebloods and a man named Louis Siana. This property was originally purchased for $48,000 and sold by the True-bloods and Siana to Penn Eastern in exchange for $75,000 of its capital stock.¹

Penn Eastern was the sole general partner in a limited partnership called The Village Center, Ltd. This partnership was formed for the development of a shopping center which was to be Penn Eastern’s sole major asset. Penn Eastern, however, began to develop severe cash flow problems in 1972. In November 1973, the Truebloods proposed acceptance of a loan to the corporation by a Frank Pierce. The plaintiffs opposed this loan, urging that it was not beneficial and that they had the financial resources to loan Penn Eastern the requisite capital. By its terms, however, the plaintiffs’ loan would have resulted in a shift in control of Penn Eastern from the True-bloods to the plaintiffs. By a 4-2 vote, the Penn Eastern Board of Directors,² rejected the plaintiffs’ proposal and accepted the Pierce loan.

The Pierce loan failed to solve Penn Eastern’s cash flow problems, and the corporation ran into difficulties meeting the loan repayments. The defendants proposed an amendment to the Pierce loan agreement by which the Red Caboose property would be sold at absolute auction in May 1975. The plaintiffs opposed this action because the real estate market was depressed, and they feared Penn Eastern would sell one of its major assets at less than its full market value. The plaintiffs offered to tender the payments due on the Pierce loan to avoid auctioning off the Red Caboose property. This proposal was rejected and the property sold.

Penn Eastern’s financial condition continued to deteriorate when in November 1975, to shore up Penn Eastern’s treasury, the defendants proposed a sale of twenty-one shares of Penn Eastern stock to Arnold Trueblood at the price of $750 per share. The plaintiffs counterproposed that Penn Eastern sell twenty shares of the stock to them at $1,000 per share. This would have resulted in a shift in corporate control to the plaintiffs, and it too was rejected and the sale to Arnold Trueblood approved. Despite the new infusion of capital arising out of the sale of stock, Penn Eastern’s financial condition continued to deteriorate.

The plaintiffs filed the present shareholders’ derivative action in the district court alleging violation of the'federal securities laws and Delaware corporate law.³ The complaint sought rescission of the sale of stock to Arnold Trueblood and damages on behalf of Penn Eastern.

During the pretrial and discovery phases of the trial, Penn Eastern, as the general partner of The Village Center, Ltd., filed for reorganization under Chapter XII of the Bankruptcy Act. Penn Eastern attempted to reorganize The Village Center, Ltd. by soliciting additional investments from the limited partners. When this proved unsuccessful, the plaintiffs were notified that no plan would be presented to the Bankruptcy Court, and that court subsequently dismissed the reorganization petition on May 30, 1978, without prejudice. Mortgage foreclosure proceedings were thereafter commenced by the mortgagee of The Village Center’s property because Penn Eastern failed to meet its mortgage obligations. The plaintiffs filed an emergency motion for the appointment of a receiver on June 23, 1978, but the motion was denied by the district court on June 26, 1978.

From approximately May 1977 onward, the trial judge assigned to the case made repeated efforts to have the parties reach a settlement. The trial was set to commence on August 21, 1978, but was postponed and a final settlement conference occurred. After it became apparent that a settlement could not be achieved, the trial judge reset the trial date for September 6,1978. Meanwhile, the multi-million dollar shopping center owned by The Village Center, Ltd. was scheduled for a foreclosure sale on August 23, 1978. The foreclosure took place as scheduled. The plaintiffs had indicated during the summer that should the shopping center be lost, they would seek amendment of their complaint to include its loss as both grounds for liability and damages.

The parties returned to court for trial on September 6, 1978. Although represented by local counsel, the plaintiffs’ active trial counsel had offices in Chicago, Illinois. The court did not commence trial, however, and instructed the parties to be available on twenty-four hours’ notice. On September 18, 1978, the Johnsons tendered their proposed amendment to the complaint relating to the loss of the shopping center. This amendment was allowed but only on the issue of damages (the trial was bifurcated as to liability and damages). On September 19, 1978, trial began, but because of numerous interruptions the district court declared a mistrial once more and reset the case for trial. Trial was now fixed for February 20, 1979. The plaintiffs retendered their proposed amendment to the complaint as to liability shortly after the mistrial, but it remained without disposition for the next three months.

In the interval between the September 1978 mistrial and the new trial date, the plaintiffs, concerned over the trial judge’s impartiality and his conduct of the trial, informally sought to have the Chief Judge of the Eastern District of Pennsylvania reassign the case. These efforts were unsuccessful. On February 7, 1979, the trial judge again rejected the proposed amendment to the complaint on the ground that it might delay the trial. Plaintiffs thereafter filed a motion on February 15,1979, to have the trial judge recuse himself pursuant to 28 U.S.C. § 144 (1976), which was denied.

Trial thereafter commenced and lasted seventy-two days. During the course of the trial, plaintiffs petitioned this court for a writ of mandamus pursuant to 28 U.S.C. § 1651 (1976) to compel the judge’s recusal. Our court denied the petition on June 27, 1979. Trial concluded on July 3, 1979, with a verdict in favor of the defendants. The plaintiffs filed a notice of appeal. After the notice was filed, the district court, without holding a hearing or providing notice, revoked the pro hac vice status of the plaintiffs’ Chicago counsel effective as of the date of the jury’s verdict. The plaintiffs and their Chicago counsel filed another notice of appeal to challenge this action. That appeal is dealt with in our separate opinion filed today.

II.

We turn first to the district court’s denial of the plaintiffs’ motion to recuse. Even a brief examination of the factual and procedural history of this case reveals the tension existing between the parties and especially between the plaintiffs and the trial judge. Unfortunately, this tension was exacerbated both by the numerous delays in bringing the case to trial, the necessity for counsel to stand by for days in expectation of being called for trial, and the length of the trial.

The plaintiffs filed a motion pursuant to 28 U.S.C. § 144, which requires the district judge to recuse himself if personal bias or prejudice against or in favor of any adverse party exists. The district judge also raised, sua sponte, whether he should recuse himself pursuant to 28 U.S.C. § 455(a), which requires recusal if the judge’s “impartiality might be reasonably questioned.” Although Congress has not indicated the precise parameters of the two provisions, we need not decide that here because both statutes require the same type of bias for recusal and it is not present in this case.

In this circuit, review by this court of a district. court’s action on recusal is by an abuse of discretion standard. See May-berry v. Maroney, 558 F.2d 1159, 1162-63 (3d Cir. 1977). In general, it seems that § 455(a) was intended only to change the standard the district judge is to apply to his or her conduct; it does not alter the type of bias required for recusal. Thus the rule under § 144 continues that only extrajudicial bias requires disqualification. See id. at 1162 n. 16. See generally H.Rep.No. 93-1453, reprinted in [1974] U.S.Code Cong. & Admin.News, pp. 6351, 6354-55.

“Extrajudicial bias” refers to a bias that is not derived from the evidence or conduct of the parties that the judge observes in the course of the proceedings. See United States v. Grinnell Corp., 384 U.S. 563, 580-83, 86 S.Ct. 1698, 1708-1710, 16 L.Ed.2d 778 (1966). Normally the judge’s rulings at trial do not constitute grounds for recusal because they can be corrected by reversal on appeal. See Smith v. Danyo, 585 F.2d 83, 87 (3d Cir. 1978); United States v. Gallagher, 576 F.2d 1028, 1039 (3d Cir. 1978), cert. denied, 444 U.S. 1040, 100 S.Ct. 713, 62 L.Ed.2d 675 (1979).

vVe have examined the affidavits and other evidence pointed to by the plaintiffs and find no extrajudicial bias in this sense. The plaintiffs first point to certain scheduling and other rulings by the district court. As noted, however, these are not a basis for recusal.

Second, the plaintiffs argue that statements made by the district court during the settlement negotiations show extrajudicial bias. For example, the judge made statements at the final settlement conference to the effect that the lawsuit had been a “personal tragedy for the defendants” who were “honest men of high character.” He also questioned the plaintiffs’ motives in bringing the lawsuit and stated that plaintiff Gilbert Johnson was unable to reason logically from A to B. The plaintiffs’ claim that these comments manifest extrajudicial bias is partially predicated on the timing of these statements — namely, at a pretrial settlement conference before any evidence had been adduced which could serve as a basis for the formulation of an opinion on the trial judge’s part.

In his opinion denying the motion to recuse, the judge explained that the challenged comments did not constitute extrajudicial bias. He stated that his remarks at the settlement conference were based on his perception of the case and were an attempt to have the parties reach an agreeable settlement. Although admitting that many of the statements “may have been intemperate,” he concluded that such statements were not sufficient to warrant recusal.

We do not believe that the challenged statements necessarily were rendered extrajudicial merely because they were made at pretrial settlement conference. See Fong v. American Airlines, Inc., 431 F.Supp. 1334, 1338-39 (N.D.Cal.1977). Such a rule would unduly hamper the judge’s ability to effectuate settlement. Moreover, the judge often can get a feel for a case prior to trial, which means that his perceptions can be based on the conduct of the parties and the evidence. Thus feelings about a case are not necessarily “extrajudicial” solely because they are made during settlement negotiations.

The relevant inquiry is whether the trial judge’s pretrial comments were linked to his evaluation of the case based on the pleadings and other materials outlining the nature of the case, or whether the comments were based on purely personal feelings towards the parties and the case. It is undeniable that statements such as the case has been a “personal tragedy” for the defendants who are “honest men” of “high character” may superficially connote an extrajudicial source of information or, as we are inclined to believe, it may have been a form of judicial coloration in an overzealous effort to settle what obviously would be a lengthy and complicated case to try. We agree with the judge’s candid concession that many of his statements may have been “intemperate.” Indeed, this experience points out the restraints and objectivity a judge must maintain in an effort to achieve a settlement and the need to refrain from comments which might lead one party to conclude that a personal bias may exist against him.

We have carefully reviewed the plaintiffs’ recusal affidavit and although the allegations are indeed troublesome, we believe on balance that they add up more to settlement fever than personal bias warranting recusal under either § 144 or § 455(a). Thus we cannot say that the district court abused its discretion in this case.. Nevertheless, we take this opportunity to caution the district judges of this circuit that they must not permit their role as a negotiator to obscure their paramount duty to administer the law in a manner that is both fair in fact and has the appearance of fairness. Although settlement is important given the rising caseload, it can lead to action that is not consistent with the judicial function.

III.

Next, the plaintiffs argue that the district court improperly charged the jury on their burden in overcoming, .the, business judgment rule. That rule, which admitted-, ly is part of the law of Delaware, provides that directors of a corporation are presumed to exercise their business judgment in the best interest of the corporation. The charge was as follows:

[T]he desire to retain control of a corporation in and of itself is an improper motive for decision of a director. Therefore, if you find by a preponderance of the evidence that the defendants acted solely or primarily because of a desire to retain control of Penn Eastern, then the presumption of the sound business judgment rule has been rebutted. However, I further instruct you that a director may properly decline to adopt a course of action which would result in a shift of control, so long as his actions can be attributed to a rational business purpose. In other words^so long as other rational business reasons support a director’s deciI'sion, the mere fact that a business decision involves a retention of control does not constitute a showing of bad faith to rebut the business judgment rule. That rule is rebutted only where a director’s sole or primary purpose for adopting a course of action or refusing to adopt another is to retain control, (emphasis supplied).

Instead of the emphasized language, the plaintiffs argue that they only needed to prove that control was “a” motive in the defendants’ various actions to rebut the business judgment rule. We disagree for two reasons.

First, the purpose of the business judgment rule belies the plaintiffs’ contention. It is frequently said that directors are fiduciaries. Although this statement is true in some senses, it is also obvious that if directors were held to the same standard as ordinary fiduciaries the corporation could not conduct business. For example, an ordinary fiduciary may not have the slightest conflict of interest in any transaction he undertakes on behalf of the trust. Yet by the very nature of corporate life a director has a certain amount of self-interest in everything he does. The very fact that the director wants to enhance corporate profits is in part attributable to his desire to keep shareholders satisfied so that they will not oust him.

The business judgment rule seeks to alleviate this problem by validating certain situations that otherwise would involve a conflict of interest for the ordinary fiduciary. The rule achieves this purpose by postulating that if actions are arguably taken for the benefit of the corporation, then the directors are presumed to have been exercising their sound business judgment rather than responding to any personal motivations.

Faced with the presumption raised by the rule, the question is what sort of showing the plaintiff must make to survive a motion for directed verdict. Because the rule presumes that business judgment was exercised, the plaintiff must make a showing from which a factfinder might infer that impermissible motives predominated in the making of the decision in question.

The plaintiffs’ theory that “a” motive to control is sufficient to rebut the rule is inconsistent with this purpose. Because the rule is designed to validate certain transactions despite conflicts of interest, the plaintiffs’ rule would negate that purpose, at least in many cases. As already noted, control is always arguably “a” motive in any action taken by a director. Hence plaintiffs could always make this showing and thereby undercut the purpose of the rule.

Second, the plaintiffs’ argument is inconsistent with Delaware case law. Although scholars have argued about how much is required under Delaware law to rebut the business judgment rule, we need not resolve that debate. See E. Folk, The Delaware General Corporation Law 75-81 (1972); Arsht, Fiduciary Responsibilities of Directors, Officers and Key Employees4 4 Del.J.Corp.L. 652, 660 (1979). At a minimum, the Delaware cases require that the plaintiff must show some sort of bad faith on the part of the defendant. See Arsht, supra. We do not think that a showing of “a” motive to retain control, without more, constitutes bad faith in this context unless we are to ignore the realities of corporate life. Accordingly, unless the plaintiff can tender evidence from which a factfinder might conclude that the defendant’s sole or primary motive was to retain control, the presumption of the rule remains.

The primary source of the “sole or primary motive” test used in the charge here is Cheff v. Mathes, 41 Del.Ch. 494,199 A.2d 548 (1964). Although the case explicitly contains this language, see 199 A.2d at 554, the plaintiffs would dismiss Cheff as' a momentary aberration in the law of Delaware. An examination of the relevant cases, however, reveals that the test was used both before and after Cheff by the Delaware courts.

For example, Bennett v. Propp, 41 Del.Ch. 14,187 A.2d 405 (1962), relied on by Cheff, expressly characterized the defendant’s actions as a “thinly veiled attempt” to retain control. 187 A.2d at 409. Indeed, a reading of the opinion as a whole reveals that the court felt that there was no reason other than control for the actions in question. We do not see how Bennett’s failure to use the talismanic phrase “sole or primary motive” in any way renders it inconsistent with Cheff.

Cases after Cheff have shown no inclination to abandon the sole or primary motive test. In Condec Corp. v. Lunkenheimer Co., 43 Del.Ch. 353, 230 A.2d 769 (1967), one of the cases relied on for this proposition, the vice chancellor made this express finding: “I have reached the conclusion that the primary.purpose of the [actions in question] was to prevent control of Lunkenheimer from passing to Condec and to cause such control to pass into the hands of U.S. Industries.” 230 A.2d at 775 (emphasis supplied). Other more recent cases have similarly spoken of “primary” motive in this regard. E. g., Petty v. Pentech Papers, Inc., 347 A.2d 140, 143 (Del.Ch.1975). Cf. Singer v. Magnavox Co., 380 A.2d 969, 980 (Del.1977) (stating that use of merger “solely” to eliminate minority violates majority’s fiduciary duty).

In short, we believe that under Delaware law, at a minimum the plaintiff must make a showing that the sole or primary motive of the defendant was to retain control. If he makes a showing sufficient to survive a directed verdict, the burden then shifts to the defendant to show that the transaction in question had a valid corporate business purpose. Because the charge fairly contains such a standard, we find no error.

IV.

A.

The plaintiffs also raise as error the district court’s refusal to permit them to amend their complaint on two occasions. The first of these concerned the loss through foreclosure in August 1978 of the shopping center that was Penn Eastern’s major asset by virtue of its general partnership interest in The Village Center, Ltd. The motion to amend was originally submitted on September 18, 1978, one day before trial was to commence. The trial judge denied the motion to amend as to liability because it might unduly delay the liability phase of the trial, but permitted the amendment as to damages. When a mistrial of the liability portion of the trial was declared, and the case reset for a February 20, 1979 trial, plaintiffs retendered their amendment as to liability for the loss of the shopping center. No action was taken until February 7, 1979, when the retendered amendment was again rejected by the court because of “the severe prejudice that would result to the defendants if the amendment were allowed, as compared with the lack of prejudice to the plaintiffs caused by disallowance, since they may of course proceed to file the claims in a separate cause of action” and because of the “possibility that an amendment would delay the trial.” The plaintiffs contend that the trial judge erred in rejecting their proposed amendment.

We need not decide whether the factors cited by the district court were sufficient to deny the amendment because in any event the foreclosure would not have been admissible .under Delaware substantive law in the liability phase of the trial. Thus any error in denying the amendment was harmless under Fed.R.Civ.P. 61.⁵

The governing rule of Delaware law in this regard is: “[Directors satisfy their burden by showing good faith and reasonable investigation; the directors will not be penalized for an honest mistake of judgment, if the judgment appeared reasonable at the time the decision was made.” Cheff v. Mathes, 41 Del.Ch. 494, 199 A.2d 548, 555 (1964) (emphasis supplied). The purpose of this rule is to protect corporate management from being judged by hindsight if a deal in fact goes sour. The sole question is management’s state of mind at the time of the transaction. No matter how other facets of the business judgment rule operate, we have found nothing to indicate that this principle does not remain good law in Delaware.

Although in some cases events subsequent to a transaction might shed light on management’s motives at the time of the transaction, such is not the case here. The plaintiff’s have pointed to nothing that would indicate that the mere fact that the shopping center was foreclosed in 1978 shows anything about the defendants’ pre1975 motives, and we can conceive of no reason why it would. Because Delaware will not look at subsequent events unless they shed light on motive at the time of the transaction, any error was harmless.

B.

The plaintiffs also attempted to amend the pleadings on the forty-third day of the trial to allege negligence on the part of the defendants in their performance of their duties as directors of Penn Eastern. This motion was made pursuant to Fed.R.Civ.P. 15(b), which permits the court to amend the pleadings to conform to the evidence of the trial. The district court denied the motion on the grounds of prejudice to the defendants because the allegation of negligence would shift the theory of the trial and force the defendants to prepare a mid-trial defense on a new issue.

Even assuming that negligence of directors states a cause of action under Delaware law, we cannot say it was an abuse of discretion under rule 15(b) to deny the motion. It is true that mere delay, in and of itself, is not grounds for denial of a motion to amend under rule 15(b). Nevertheless, when the delay combines with other extrinsic factors that result in actual prejudice to the party opposing the motion, denial is appropriate. Cf. Deakyne v. Commissioners of Lewes, 416 F.2d 290, 299-301 & n.19 (3d Cir. 1969) (amendment should have been permitted because no prejudice other than delay).

Here, as our recitation of the facts shows, the trial of the case had been protracted. Yet the plaintiffs have not explained why they failed to assert their negligence theory sooner. Indeed, the amendment was based primarily on a deposition that the plaintiffs sought to introduce in their own case in chief that had been taken quite some time prior to trial. Moreover, the plaintiffs were asserting a new theory that arguably would have prejudiced the defendants due to the fact that the events upon which the claims were made were rather stale by the time of the proposed amendment. Accordingly, we cannot say that the district court abused its discretion.

V.

We have examined the remainder of the plaintiffs’ contentions and find no reversible error. The judgment will be affirmed.

1 . The Johnsons each paid $25,000 for their 25 shares in Penn Eastern. Samuel and Arnold Trueblood and Siana received 25 shares of Penn Eastern in exchange for their one-third interest in the Red Caboose property. Siana’s 25 shares were repurchased by the corporation on August 21, 1978. Later purchases of stock by the Johnsons and Harry Salwen resulted in the 47 percent-53 percent split in ownership of Penn Eastern.

2 . The Board of Directors was composed of the Truebloods, Salwen, the Johnsons, and Roliand Henderson, a nonshareholder director. The Truebloods, Salwen and Henderson voted in favor of the Pierce loan; the Johnsons against it.

3 . The complaint may be broken down into four basic charges:

1. The Truebloods knowingly misrepresented to Gilbert Johnson the value of the Red Caboose property when it was sold to Penn Eastern in 1968 in exchange for Penn Eastern stock.

2. The rejection of the Johnsons’ proposed loan and acceptance of the Pierce loan was motivated by the defendants’ determination to retain control over Penn Eastern regardless of the corporation’s best interests and was accordingly a breach of fiduciary duty.

3. The rejection of the Johnsons’ loan in favor of selling the Red Caboose property at absolute auction to meet the payments of the Pierce loan was in the disinterest of Penn Eastern and motivated by the defendants’ desire to retain control over it.

4. The rejection of Gilbert Johnson’s offer to purchase twenty shares of Penn Eastern stock and acceptance of the Truebloods’ loan proposal constituted breaches of fiduciary duty by the defendants.

The issues raised on appeal concern only the state law claims.

4 . We are advised that the correct title is:

The Business Judgment Rule in Delaware and Its Applicability To The Fiduciary Responsi-

bilities of Directors, Officers and Controlling Stockholders.

5 . At least one commentator has noted that courts are split on whether the merits of an amendment are proper matters to be considered by a district court under rule 15(a). See 3 Moore’s Federal Practice *' 15.08[4], at 15 105. We are not presented with that question, however, because the district court did not address this question. On appeal, however, we are required to address the merits because we may only reverse for errors that satisfy rule ' 61.