Spirt v. Bechtel

232 F.2d 241, 50 A.F.T.R. (P-H) 1085, 1956 U.S. App. LEXIS 4835

Opinions

SWAN, Circuit Judge.

This is a stockholder’s derivative action brought on behalf of the United States Lines Company against directors and officers of said corporation who are alleged to have received unlawful compensation and to have profited through breach of fiduciary duties. The complaint was filed October 24, 1949. Federal jurisdiction is based on diversity of citizenship. The defendants, other than the corporation, are nine directors who served for various periods between January 1, 1943 and December 31, 1949, and the estates of three deceased directors. Trial to the court without a jury was had on documentary evidence and pretrial depositions. The issues were limited to the existence of liability, the amount of recovery, if any, being left for a future accounting. Judge Palmieri gave judgment for the defendants. The plaintiff has appealed.

The trial court’s opinion is reported in D.C., 129 F.Supp. 872. The facts therein set out need not be here repeated. When desirable for the discussion additional facts will be mentioned. The complaint alleges three causes of action, which will be considered seriatim. The first seeks recovery of “option profits,” by which is meant the difference between the price of $5.81 per share paid to the corporation by the optionee upon exercising his option and the market value of the shares thereby acquired. It is the plaintiff’s theory that, if the optionee’s fixed salary for the year when the option was exercised, plus his option profits, exceeded $25,000, the excess is recoverable by the corporation as “compensation” received by the optionee in violation of the statutory limit imposed by sections 805(c) and (f) of the Merchant Marine Act, 46 U.S.C.A. § 1223 (c) and (f), set out in the margin.¹

During the years in which the options were exercised the corporation was a “contractor” within the meaning of section 805(c) and received subsidies under the Merchant Marine Act. The parties are in dispute as to whether the statutory provisions create in the subsidized ship operator the right to recover the excess above $25,000 per annum received by any director, officer or employee, the defendants contending that § 805(c) was intended only to safeguard the public interest in the expenditure of governmental subsidies granted to maritime carriers, and was not designed to create private rights and obligations.² The trial judge did not pass on this contention, since he found no violation of § 805(c). Nor need we pass on it, since we agree with his determination that the “option profits” were not “compensation” for personal services within the meaning of the section.

Footnotes

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*

The purpose of the stock option plan, approved by the stockholders in May 1943, was to permit the Board of Directors to allot, “with due regard for meritorious service,” stock options to key officers and employees as an inducement to those in the employ of the corporation to continue therein and to those absent in war activities to return to the company when their war activities ceased, and to encourage all optionees to strive more diligently for the company’s success. On November 30, 1943, the Board of Directors, acting through an authorized committee, granted stock options to eight officers and 39 other employees.³ The option price of $5.81 was based on the average market price during the preceding 30 consecutive trading days; it was slightly above the market price of November 30, 1943.⁴ The options were to run for five years and were exercisable after June 15, 1944 in ten per cent, instalments if the optionee had remained in the company’s employ for the preceding six months. Optionees on leave of absence of war service could not exercise their options until after returning to the company’s employ. For reasons unnecessary to detail none of the options was exercised before November 26, 1945. On that date, which was shortly after the company had received from the General Counsel of the United States Maritime Commission a letter expressing his opinion that the difference between the option price and the market price at the time of exercising the option would not be regarded as compensation for services within the meaning of section 805(c), the optionees were notified that they were at liberty to exercise their options. Options for 1,100 shares were exercised in ,1945, for 44,832 shares in 1946, for 24,066 shares in 1947 and for 18,484 shares in 1948 — a total of 88,482 shares.^{5 6}It was stipulated that if the option profits' are treated as compensation, at least 14 of the optionees, seven of whom have appeared as defendants, received annual compensation in excess of $25,000 for one or more of the years 1946 to 1948.

Judge Palmieri followed the opinion expressed by the General Counsel for the Maritime Commission. We agree with the plaintiff that the General Counsel’s opinion was not an administrative ruling by the Maritime Commission itself and need be followed by the courts only in so far as its reasoning is persuasive.⁶ The plaintiff makes a powerful argument against the correctness of the trial court’s decision, but it does not convince us. It is true that before exercising his option to take up any part of the optioned shares, the optionee must have worked for the company for a specified period of time; that continuation in the employ of a corporation has been held to be the consideration which validates a stock option,⁷ and that for tax purposes exercise of a stock option may give the optionee compensation in the amount of the difference between the option price and the market price of the shares acquired by exercise of the option.⁸ But no authority has been cited which construes “compensation” as used in section 805(c) of the Merchant Marine Act to include such so-called “option profits.” The meaning of “compensation” as there used is to be determined by the purpose of the statute. That purpose was to develop a strong merchant marine and to compel subsidized corporations to operate on a sound basis and not waste their assets by paying exorbitant salaries. One of the customary ways for a corporate employer to retain a competent personnel was to offer valuable officers and employees “incentive” stock options to induce them to continue to serve and to give them a financial interest in the corporation’s success by investment in its stock. We cannot believe that the Congress meant to prohibit this customary method of developing efficient management by limiting the annual “compensation” receivable by such officers and employees. The plaintiff says that the leg islative history of section 805(c) shows that one purpose of the statute was to prevent undercapitalization of subsidized operators, and argues that, except for the stock options, the corporation could itself have sold the shares at their market price when the options were exercised. But plainly the statute did not forbid all incentive stock options. Even on the plaintiff’s theory the exercise of such an option was unassailable unless it resulted in the optionee receiving in excess of 825,000 per year. We do not believe that the Congress intended by section 805 (c) to discriminate between stock options all of which were unassailable when granted but some of which, if the corporation prospered, through development of an efficient organization, were certain to become assailable under the $25,-000 limitation of “compensation,” if that were to be applied. In our opinion dismissal of the first alleged cause of action was correct.

The second cause of action asserts liability of the defendants to account for tax losses sustained by the corporation and tax advantages gained by the optionees by reason of the corporation’s relinquishment of any claim to tax deductions attributable to the stock options. The theory is that each optionee was subject to income tax on the amount of his “option profits” in the year when he exercised his option, and the corporation was entitled to deduct a corresponding amount from its gross income in figuring its own income tax for that year; and that in order to relieve the optionees from their income tax liability, the defendants, “in breach of their fiduciary duties,” caused the corporation to exercise and file with the Commissioner of Internal Revenue, Its consent not to claim any deductions attributable to the stock options in its own tax returns.

On April 12, 1946 the Commissioner of Internal Revenue promulgated a ruling known as I.T. 3795 (1946 — 1 C.B. 15). It dealt with employees’ stock options granted before February 26, 1945 (the date of the decision of Commissioner of Internal Revenue v. Smith, 324 U.S. 177, 65 S.Ct. 591, 89 L.Ed. 830), recognized that under tax decisions before the Smith case there might be reasonable doubt as to the compensatory nature of stock options, and provided an expeditous method of obtaining a ruling as to the tax consequences of the exercise of the options. On May 2, 1946 Mr. Franklin, president of the corporation, acting upon the advice of counsel, requested a ruling under I.T. 3795. Counsel had advised that in his opinion the options were non-compensatory, and that the corporation had no right to claim deductions in the amount of the optionee’s “profits,” and should, in its request for a ruling, offer to file the consents prescribed in I.T. 3795. In response to this request, the acting Commissioner, under date of May 31, 1946, wrote that “ * * * no ‘income’ will be realized by your officers and employees upon the exercise or transfer of the options in question provided that such officers and other employees and you as their employer each file, on or before July 1, 1946, the consents required under the provisions of the next to the last paragraph of I.T. 3795.”⁹ The treasurer of the corpora tion, Mr. Gibbons, sent a copy of this ruling to the optionees with a request that they execute their consents. Mr. Hicks, vice-president of the corporation, executed the corporation’s consent, and all consents were filed with the Commissioner before July 1, 1946.

The trial judge was of opinion that in approving the stock option plan the stockholders “must be deemed to have concurred in its tax consequences, whatever they might be, and in all steps that the directors and officers might reasonably take to implement the plan”; and that defendant Hicks’ signing of the corporation’s consent not to claim a deduction on account of the stock options was “such an act of implementation.” We agree that the stockholders approved the tax consequences of the plan, “whatever they might be,” but the proxy statements upon which the stockholders acted said not a word about taxes and we cannot agree that the consent signed by Mr. Hicks was a mere “implementation” of the tax consequences of the plan, if the corporation’s ■ consent changed the tax consequences, as the plaintiff contends it did. As to this the trial judge assumed that the corporation did have the legal right to deduct the amount of the option profits from its gross income but found the right so doubtful that execution of the corporation’s consent was not á breach of fiduciary duty but an act within the discretion of the officers. We address ourselves to this aspect of the case.

We are not entirely clear whether the plaintiff charges all the defendants with breach of fiduciary duty or only defendants Franklin and Hicks.¹⁰ The optionees as such were under no fiduciary duty to the corporation. Such tax advantages as the stock options gave-them they were entitled to keep. We cannot see that as optionees they owedi the corporation a fiduciary duty to refrain from filing their own consents under I.T. 3795 in order to nullify the effect of the consent the company proposed to file. As directors the defendants did owe the corporation fiduciary duties not to waste or give away its assets. But as directors they were not consulted as to waiving the company’s right to claim at tax deduction in connection with the exercise of the options. Having taken no part in the waiver, they cannot be charged as directors with giving away a corporate asset. Any claim of liability on the part of the defendants as directors must be predicated on negligence in not preventing the officers of the corpora-! tion from filing its consent. As the opinion below points out, the right of the corporation to a tax deduction on account of the stock options was far from clear under prior decisions of the Board of Tax Appeals and the ruling of the Acting Commissioner. It is true that in 1950 the Tax Court construed I.T. 3795 as instructing the Commissioner’s staff “that upon the filing of such consents any controversy must automatically be closed in the taxpayer’s favor.” ¹¹ But the directors are not chargeable with foreseeing this later ruling. As matters stood in 1946, the corporation’s right to a tax deduction was very doubtful.¹² We do not think the board of directors can be held liable for negligence in not having prevented the filing of the company’s consent.

We turn now to the question whether the officers who took part in waiving the corporation’s doubtful claim to a tax deduction incurred liability thereby. Certainly the corporation was entitled to submit its tax problems to the Commissioner of Internal Revenue and request a ruling on them. Mr. Franklin, the president, was an appropriate officer to present the request. We do not think he is chargeable with a violation of fiduciary duty in doing so merely because he would personally get tax advantages if the Commissioner ruled one way and the corporation would get them if the Commissioner ruled the other way. A corporate officer’s fiduciary duty is violated when he acts on behalf of his corporation in a matter where he has a personal interest which may influence his judgment with respect to the corporation’s interests.¹³ Here there did not appear to be any conflict between his own interest and the corporation’s interest, for counsel, Mr. Fridlund, had advised him that it would be a “fraud on the revenue” for the company to claim a tax deduction. His interest and the corporation’s were the same, namely, to get a speedy ruling by the Commissioner; the alternative was to litigate in court a claim which in counsel’s opinion was baseless. In our opinion it was within the president’s discretion to select the former alternative. The foregoing discussion with respect to Mr. Franklin’s request for the ruling applies with equal force to Mr. Hicks’ execution of the corporation’s consent after the ruling was obtained. He was present when Mr. Fridlund expressed the opinion that the claim was baseless.

The appellant contends that Truncale v. Universal Pictures Co., Inc., D.C.S.D. N.Y., 76 F.Supp. 465 is a case “on all fours with this case and does not require discussion.” We think a vital distinction exists in the fact that there the defendants, who caused the corporation’s consent to be filed with the Commissioner, had not been advised by counsel that the corporation had no right to claim a tax deduction on account of the options. No authority has been found which discusses whether counsel’s advice that a cestui has no valid claim — and consequently no interest adverse to the fiduciary’s interest — will protect the fiduciary from liability for waiving the claim instead of litigating it. Whether a conflict of interests existed was a question of fact, the answer to which turned on a question of law. Counsel’s opinion as to the law (even though erroneous) should, in our opinion, protect the officers acting in reliance upon it.¹⁴ Accordingly dis missal of the second Cause of action was correct.

The third alleged cause of action is for giving directors, members of their families and servants free transportation or transportation at reduced rates. No statute authorized this practice. Nor can it be defended in our opinion on the ground of custom or of approval by the Maritime Commission and its successor of the Atlantic Conference Agreement to which the United States Lines Company was a party. Perhaps some of the free trips by directors can be justified as a means of educating them regarding the company’s business and the operation of its vessels, but this could scarcely be stretched to include members of a director’s family or servants, and certainly not when they traveled without the director. As to trips not so justifiable, free or reduced-rate transportation was a gift which the corporate officers were not authorized to make and for which the donees must account.

For the foregoing reasons we conclude that the judgment must be reversed as to the third cause of action and the cause remanded for further proceedings consistent with this opinion.

1

. “Limitation on wages, salary, or compensation of director, officer, or employee of contractor

“(c) No director, officer, or employee (which terms shall be construed in the broadest sense to include, but not to be limited to, managing trustee or other administrative agent) shall receive from any contractor, holding a contract authorized by sections 1171-1182 or 1191-1204 of this title and its affiliate, subsidiary, associate, directly or indirectly, wages, salary, allowances of compensation in any form for personal services which will result in such person’s receiving a total compensation for his personal services from such sources, exceeding in amount or value $25,000 per annum, and no such person or concern shall be qualified to receive or thereafter to hold any contract under this part, if such person or concern, its subsidiary, affiliate, or associate pays or causes to be paid, directly or indirectly, wages, salary, allowances, or compensation in any form for personal services which result in such person’s receiving a total compensation for his personal services from such sources exceeding in amount or value $25,000 per annum.

*****

“Penalty

“(f) Any willful violation of any provision of tbis section shall constitute a breach of the contract or charter in force under this chapter, and upon determining that such a violation has occurred the Commission may forthwith declare such contract or charter rescinded and any person willfully violating the provisions of this section shall be guilty of a misdemeanor.”

2

. Cf. Odell v. Humble Oil & Refining Co., 10 Cir., 201 F.2d 123, 127, certiorari denied 345 U.S. 941, 73 S.Ct. 833, 97 L.Ed. 1367.

Judge Swan agrees with Judge Lumbard’s separate concurring opinion but adheres to his own opinion as an additional ground for aflirmance of the district court’s dismissal of the first cause of action.

3

. Several of the directors were optionees, but they were not granted options as such. The plan provided: “Directors as Such shall not be eliglible to receive such options, but officers or other eligible employees who are also directors may be granted such options.”

4

. The plaintiff makes no contention that the granting of the option increased the “compensation” of any officer or employee.

5

. The “option profits” aggregated $1,186,-667.49.

6

. Colby v. Klune, 2 Cir., 178 F.2d 872, 875, footnote 15; see also Jewell Ridge Coal Corp. v. Local No. 6157, etc., 325 U.S. 161, 169, 65 S.Ct. 1063, 89 L.Ed. 1534.

7

. See Eliasberg v. Standard Oil Co., 23 N.J.Super. 431, 92 A.2d 862, affirmed 12 N.J. 467, 97 A.2d 437; Gottlieb v. Heyden Chemical Corp., Del., 90 A.2d 660, 664; Id., Del., 92 A.2d 594, 598; Clamitz v. Thatcher Mfg. Co., 2 Cir., 158 F.2d 687, 692, certiorari denied 331 U.S. 825, 67 S.Ct. 1316, 91 L.Ed. 1841; Steinberg v. Sharpe, D.C.S.D.N.Y., 95 F.Supp. 32, 33, affirmed on opinion below, 2 Cir., 190 F.2d 82.

8

. Commissioner of Internal Revenue v. Smith, 324 U.S. 177, 65 S.Ct. 591, 89 L.Ed. 830.

9

. This paragraph reads as follows:

“Accordingly, in view of the prior development of the regulations an [sie] interpretations relative to employee stock options (see T.D. 3435, (1923) II-l 0.15. 50; I.T. 3201, 1938-2 C.B. 120; T.D. 4879, 1939-1 O.B. 159), as respects an option granted to an employee prior to February 26, 1945, unless at the time such option was granted, there was a substantial difference between the fair market value of the stock and the option price therefor, or, within the purview of section 29.22(a)-! of Regulations 111 prior to the amendments made by Treasury Decision 5507, supra, the employee would otherwise clearly realize income by way of compensation through the exercise or transfer of the option, this office will hold that the exercise or transfer of such option, as the case may be, does not result in income to the employee by way of compensation under the principles enunciated in the preceding paragraphs, provided, however, that on or before July 1, 1940, the employee to whom such option is granted and any transferee thereof, and the employer cor poration or any other taxpayer who granted such option to the employee, file in duplicate with the Commissioner of Internal Revenue at Washington, D. C., written consents (1) agreeing that the basis to the employee, and to any transferee of the option, for the stock acquired or to be acquired, pursuant to the option shall be the actual price paid therefor and. that no deduction shall at any time be claimed attributable to any aspect of the option arrangement, under section 23(a) (1) or any other subsection of the Internal Revenue .Code [26 U.S.C. A.], by the employer corporation or the taxpayer who granted the option, and (2) indemnifying the Commissioner against the filing of a claim for credit or refund, or any other action by any taxpayer concerned, inconsistent with the consents filed.”

10

. Appellant’s brief at page 52 says:

“In May and June 1946 defendants Franklin and Hicks, acting as president and executive vice-president of the Corporation, waived the Corporation’s right to claim a tax deduction in connection! with the exercise of the options. Both of' these men held large amounts of the options. ‘ Both stood to derive large personal tax advantages by sacrificing the-rights of the Corporation. They sacrificed. those rights in order to save their-own taxes. They did this without consulting the board of directors, let alone-the stockholders of the Corporation. The-other defendant optionees joined in this-, self-serving conduct by filing their consents; each of them was a director, each» shifted his tax burden to the Corporation.”.

11

. Malcolm S. Clark, 9 T.C.Memo 719, 722.

12

. See the numerous cases cited in Commissioner of Internal Revenue v. Lo Bue, 3 Cir., 223 F.2d 367, certiorari granted 350 U.S. 893, 76 S.Ct. 151.

13

. See Bogert, Trusts and Trustees, § 543:

“One of the most fundamental duties of the trustee is that he must display throughout the administration of the trust complete loyalty to the interests of the cestui que trust. lie must exclude all selfish interest and also all consideration of the welfare of third persons.”

14

. Somewhat analogous is illustration 3 in comment b of § 201, Restatement, Trusts:

“3. By the terms of a trust the trustee is directed to invest only in first mortgages. He purchases a mortgage which he believes to be a first mortgage, having obtained the opinion of competent counsel that it was a first mortgage. The opinion of counsel was based upon a decision of the Supreme Court of the State, which was overruled after the trustee made the purchase. The trustee is not liable for breach of trust in making the investment.”