SECURITIES LAW
by Jayne Zanglein * and Alison Myhra**
I.
II.
INTRODUCTION
CUSTOMERS
III.
VI.
VII.
377
.
377
LIABILITY FOR FAILURE TO PROVIDE OPTIONS DISCLOSURE DOCUMENTS
IV.
V.
.
SCOPE OF DUTIES OWED BY COMMODITY BROKERS TO
.
STATUTE OF LIMITATIONS FOR IOb-5 ACTIONS
..
382
385
NONDISCLOSURE OF ENTRENCHMENT DEVICES IN PROXY
FIGHTS ••••••••••••••••••••••••••••••••••..•••.••••••.•.••.•••..•..•.•
388
WAIVER OF INTRASTATE EXEMPTION
391
.
ATTORNEYS' FEES AWARDS IN SHAREHOLDER DERIVATIVE ACTIONS
.
I.
393
INTRODUCTION
During the survey period, the Fifth Circuit did not make any
significant advances into previously uncharted areas of securities law.
This article will not examine every securities case issued during the
survey period. Instead, we will focus on those cases which presented
interesting issues.
II.
SCOPE OF DUTIES OWED BY COMMODITY BROKERS TO CuSTOMERS
The Fifth Circuit, faced with a case of first impression under
Mississippi law, certified several questions to the Mississippi Supreme
Court concerning the scope of fiduciary duties owed by a commodities
broker to customers in a non-discretionary account. I Specifically, the
questions certified include whether a commodities broker has a fiduciary duty to advise a customer to stop trading where the broker
knows that the customer is trading excessively and irrationally; where
• Associate Professor of Law, Texas Tech University; B.M.E., Berkee College of Music,
1975; J.D., State University of New York at Buffalo, 1980.
•• Assistant Professor of Law, Texas Tech University; B.A., B.S.Ed., University of Nonh
Dakota; J.D., University of North Dakota; L.L.M., Harvard Law School.
1. 903 F.2d 1014, 1022 (5th Cir. June 1990), amended by 919 F.2d 992 (5th Cir. Dec.
1990), certifying questions to No. 9O-FC-1321, 1991 WL 191654 (Miss. Sept. 18, 1991) (not yet
released for publication).
377
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the customer lacks the experience and ability to trade commodities;
where the customer's continued trading is likely to jeopardize life
savings; or where the customer initiates the trades, directs the broker
to execute the trades, and understands the risks involved. 2
Puckett v. Rufenacht, Bromagen & Hertz, Inc. 3 involved "the
commodity futures trading tragedy of Dr. and Mildred Puckett."4
After hearing a sales presentation by Rufenacht, Bromagen & Hertz,
Inc. (RB & H), Dr. and Mrs. Puckett opened an account with RB &
H.S The account was· non-discretionary; the broker had no authority
to execute trades unless directed by the Pucketts. 6 Although the
Pucketts informed RB & H that collectively they had $40,000 of risk
capital available for investment, this amount "became unimportant to
Dr. Puckett once he began trading and he decided to risk more money
as time went on."7 Over the next three years, Dr. Puckett lost more
than $2 million. 8 He began to liquidate his pension plan to cover his
trading 10sses.9 Dr. Puckett's son discovered the size of the losses and
20
Two questions were certified to the Mississippi Supreme Court:
1. Under Mississippi law, what duty of care does a commodities broker owe to
commodities customers in a non-discretionary account: (i) is the duty only properly to
execute trades as directed by the customer, or (ii) is the commodities broker required
to exercise that degree of care which a commodities broker of ordinary professional
skill and prudence would exercise under similar circumstances?
20 Under Mississippi law, does a fiduciary duty exist between a commodities broker
and a commodities customer with a non-discretionary account; if so, does that duty
extend to require a commodities broker to: (i) advise a customer to discontinue trading
if the commodities broker knows or has reason to know that the customer is trading
excessively and irrationally, or (ii) that the customer lacks the experience and ability
to trade the commodities which he is trading, or (iii) that the customer has already
incurred losses which are very high in proportion to the customer's net worth, so that
there is a high probability that the customer will lose his entire net worth if he
continues to trade commodities or (iv) is such duty affected where the customer initiates
the ideas for the trades, presumably understands the risks and potential rewards of
the trades, directs the broker to execute the trades, and does not ask the broker is
there a duty to determine and monitor whether the trades are suitable for the customer?
If under Mississippi law, there is such a duty of care is it subject to the doctrine of
assumption of risk?
919 Fo2d at 9940
30 903 F02d 1014 (5th Ciro June 1990)0
40 [do at 10150
So [do at 10160
60 [do
70 [do at 10170
80 [do
9. [do
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advised his father to stop trading. 1o Dr. Puckett followed this advice
and told his broker that he was quitting "because he had lost enough."ll
He made no complaints about the way his broker handled his accountY
The Pucketts sued RB & H under state and federal law.13 The
Pucketts alleged that RB & H had violated section 4(b) of the
Commodity Exchange Act l4 by misrepresenting material facts, failing
to disclose the risks of commodities trading, and breaching its duty
to determine Dr. Puckett's suitability for trading futures. IS Because
the Commodity Exchange Act does not preempt common law remedies,16 the Pucketts also sued RB & H for negligence and breach of
fiduciary duty under state law. 17 In their state law claims, the Pucketts
alleged that RB & H negligently failed to follow internal and industry
standards in its dealings with the Pucketts. 18 The Pucketts also contended that RB & H negligently permitted Dr. Puckett to trade S &
P index futures, which exposed the trader to unlimited losses, when
the broker had little knowledge about such contracts, knew Dr. Puckett
had no experience trading on the S & P index, and knew that Dr.
Puckett already had lost $500,000 trading futures. 19
The trial court granted summary judgment in favor of RB & H
on all counts. 20 The Fifth Circuit affIrmed the trial court's ruling that
no violation of the Commodity Exchange Act had occurred and
certified to the Mississippi Supreme Court questions of state law
relating to negligence and breach of fiduciary duty.21
The Pucketts alleged that RB & H violated section 4(b) of
the Commodity Exchange Act22 by misrepresenting material facts. 23 In
10. [d.
11. [d.
12. [d.
13. [d.
14. 7 U.S.C. §§ 1-26 (1988).
15. 903 F.2d at 1017·18.
16. See Kotz v. Bache Halsey Stuan, Inc., 685 F.2d 1204, 1207-08 (9th Cir. 1982).
17. 903 F.2d at 1020.
18. [d. at 1021.
19. [d.
20. [d. at 1015.
21. [d.
22. Section 4b of the Commodity Exchange Act makes it
unlawful for any [person] . . . in or in connection with any order to make, or the
making of, any contract of sale of any commodity in interstate commerce, made, or
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determining whether a violation of section 4(b) occurred, the court
sought guidance from the common law definition of fraud. 24 Under
Mississippi law, a plaintiff who alleges common law fraud must prove
that the defendant made a false representation of material fact,
knowing that the statement is false or being ignorant of its truth. 2S
Further, at the time of the misrepresentation, the defendant must have
intended that the plaintiff rely on the statement. 26 Finally, the plaintiff
must have justifiably relied on the statement without knowledge as to
its falsity and must have suffered consequent and proximate injury. 27
The Fifth Circuit held that the Pucketts were not entitled to recovery
under section 4(b) of the Commodity Exchange Act because they failed
to prove these necessary elements of common law fraud in Mississippi. 28
Based on Dr. Puckett's clear testimony that his broker had made no
false statements, the court found no evidence of misrepresentation. 29
The Pucketts also alleged that their broker violated section 4(b)
of the Commodity Exchange Act by failing to sufficiently inform them
of the risks of trading commodities. 30 The Fifth Circuit held that,
although section 4(b) of. the Commodity Exchange Act subjects a
broker to liability for misrepresentations or omissions with respect to
to be made, on or subject to the rules of any contract market, for or on behalf of
any other person, . . .
(A) to cheat or defraud or attempt to cheat or defraud such other person;
(8) willfully to make or cause to be made to such other person any false report or
statement thereof, or willfully to enter or cause to be entered for such person any
false record thereof;
(q willfully to deceive or attempt to deceive any such other person by any means
whatsoever in regard to any such order or contract or the disposition or execution of
any such order or contract, or in regard to any act of agency performed with respect
to such order or contract for such person; ...
7 V.S.c. § 6b (1988).
23. 903 F.2d at 1017.
24. Id. at 1018.
25. Id. at 1018 n.3.
26.
27.
28.
See id.
See id.
Id. at 1018. The court further noted that the Pucketts failed to meet the standard of
the First, Second, Eighth, Ninth, Tenth, and D.C. Circuits which have also defmed fraud under
the Commodity Exchange Act. Id. These definitions vary from the Eighth Circuit's test (similar
to the Mississippi standard), to the D.C. Circuit, which has held that "reckless inattention to
obvious dangers to a client's interests in arranging a purchase or sale for the client's account
triggers liability under section 4(b)." Compatr! Hom v. Ray E. Friedman & Co., 776 F.2d 777,
7SO (8th Cir. 1985) (Eighth Circuit test) with Drexel Burnham Lambert Inc. v. Commodity
Futures Trading Comm'n, 8S0 F.2d 742, 748 (D.C. Cir. 1988) (D.C. Circuit test).
29. See 903 F.2d at 1018.
.
30. Id. at 1017.
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the risks of trading commodities futures, the Pucketts failed to prove
a violation. 3! The Fifth Circuit affirmed the lower court's finding that
Dr. Puckett was an experienced businessman who understood the risks
involved in commodities trading. 32 When the Pucketts opened discretionary accounts with RB & H, they signed risk disclosure statements. 33
The court noted that a risk disclosure statement may not, in all cases,
be enough to "absolve a broker of all duty to disclose material
information about risk."34 However, in this case, the risk disclosure
statement was sufficient because Dr. Puckett was an educated and
successful businessman who had traded securities for more than thirty
years, was capable of understanding the risk disclosure statement, and
admitted that he affirmatively sought risk in order to make profits. 35
The Fifth Circuit concluded that the Pucketts were sufficiently informed as to the risks involved. 36
The court also rejected the Pucketts' claim that RB & H had
failed to determine their suitability to trade commodities futures under
section 4(b) of the Commodity Exchange Act. In support of its ruling,
the court cited Phace/li v. ContiCommodity Services, Inc.,37 in which
the Commodity Futures Trading Commission held that a commodities
broker has no duty to determine a client's suitability to trade. 38 The
Fifth Circuit in Puckett held that "RB & H had no duty to determine
if Dr. Puckett was a suitable candidate for commodity futures trading. "39
The Mississippi Supreme Court recently responded to the questions
certified by the Fifth Circuit. Judge Hawkins noted that RB & H
could be accused of committing only one sin: "[S]tanding by while
31. Id. at 1018-19.
32. Id. at 1019.
33. Id.
34. Id.
35. Id. at 1017.
36. Id. at 1020. The court acknowledged that Dr. Puckett's strongest federal claim related
to his S & P Index trading. Id. At first, Dr. Puckett was not aware how fast the contracts could
move, but became aware of this risk when he lost $65,000 in one day; he continued to trade S
& P Index contracts after incurring that loss. [d. The court stated, "a claimant who suffers
losses after learning the risk of trading cannot recover for earlier reliance upon misrepresentations
about risk." [d. (quoting Clayton Brokerage Co. v. Commodity Futures Trading Comm'n, 794
F.2d 573, 578-79 (11th Cir. 1986».
37. Comm. Fut. L. Rep. (CCH) , 23,250 (C.F.T.C. 1986).
38.
See id.
39. 903 F.2d at 1020.
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Dr. Puckett committed fiscal hari-kari."4O He framed the issue as
"whether RB & H can be held liable to the Pucketts under the
common law of this State based on [the broker's] ... total silence
and passivity during Dr. Puckett's protracted self-immolation."41 In
grandiose rhetoric, re~ounding of freedom and responsibility, Judge
Hawkins stated:
One word encompasses all the grandeur and majesty of western
civilization. That word is "freedom." ...
If a society is to be free, it must demand of every person who,
complete on his own, makes a mistake that he has no legal right
to shift from his shoulders onto another's the suffering it causes....
It may be morally reprehensible for one man to watch another
open a window on the twentieth floor of a skyscraper, climb
through it and jump out, when he could easily have reached out
and stopped him. To impose a legal responsibility upon the bystander to stop him, however, is an entirely different matter. 42
.
Judge Hawkins concluded that a broker in a non-discretionary account
has only one duty: To properly carry out the customer's instructions. 43
"[O]rdinarily, his fiduciary duty ends there. He has no further duty
to advise or counsel as to the wisdom of his customer's trades."44
Although the court noted that custom may require commodities brokers to warn customers who are making imprudent and foolish trades,
no evidence of such custom could aid Dr. Puckett, since the terms of
the commodities trading were clear and unambiguous. 45 Where a
contract is clear and unambiguous, "no evidence of custom can be
permitted to change them."46 Judge Hawkins concluded that trade
customs were not designed to protect an investor such as Dr. Puckett,
"from his own greed. "47
III.
LIABll.ITY FOR FAILURE TO PROVIDE OPTIONS DISCLOSURE
DOCUMENTS
In Jolley v. Welch,48 a securities churning case, the Fifth Circuit
briefly touched upon a myriad of issues. The case was a consolidation
40. Puckett v. Rufenacht, Bromagen & Hertz, Inc., No. 9O-FC-132I, 1991 WL 191654 at
n.5 (Miss. Sept. 18, 1991) (not yet released for publication).
41.
42.
43.
44.
45.
46.
47.
[d.
[d.
[d.
[d. at n.6.
48.
904 F.2d 988 (5th Cir. July 1990), cert. denied, III S. Ct. 762 (1991).
[d. at n.9, 10.
[d. at n.9.
[d.
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of eight separate lawsuits brought by dissatisfied Paine Webber. customers, who alleged that their broker, James Welch, traded "without
their authorization, . . . invested in speculative and unsuitable stocks,
churned [their] ... accounts, failed to provide 'options disclosure
documents' ., ., and forged arbitration agreements."49 Plaintiffs sued
under the Securities Exchange Act of 1934,50 Louisiana Civil Code,
RICO, and rules promulgated by the National Association of Securities
Dealers and the New York Stock Exchange.51 The jury found no
violation of RICO but did find violations of federal securities law and
state law and awarded damages in favor of all eight plaintiffs. 52 On
appeal, the Fifth Circuit affirmed the lower court's decision.53
Plaintiffs challenged the jury's verdict that no violation of RICO
hadoccurred. S4 Plaintiffs apparently contended that this verdict was
inconsistent with the jury's finding of a section 10(b) violation.55 The
Fifth Circuit rejected this contention and noted that the jury's verdicts
could be reconciled. 56 The Court explained that the jury may have
concluded that a single act or unrelated acts of churning occurred,
which is sufficient to constitute a section 1O(b) violation but is insufficient to establish a pattern of racketeering. 57
The Fifth Circuit also affirmed the lower court's ruling that a
claim for manipulative practices in violation of section 9 of the
Securities Exchange Act requires either proof that the manipulative
practices "artificially affected the market price of any security" or
proof that plaintiffs had purchased a security at an artificial price. 58
Section 9(b) prohibits certain manipulative practices in the trading of
securities. 59 Rule 9b-l requires a broker-dealer to provide options
49. Id. at 990.
50. 15 U.S.C. §§ 78a-78kk (1988).
51. 904 F.2d at 990. Plaintiffs requested a jury instruction on unsuitability under the NYSE
Rule 405 ("Know Your Customer Rule") and NASD Manual, article III, section 2 ("Suitability
Rule"). Id. at 993. The jury "instruction would have informed the jury that unsuitability may
be deemed a discrete violation of Rule IOb-5." Id. Although the Fifth Circuit has previously
ruled that a jury may consider these rules in determining if churning occurred, the court refused
to remand this case because plaintiffs had prevailed on their IOb-5 claims. See 904 F.2d at 993.
See also Miley v. Oppenheimer & Co., 637 F.2d 318, 333 (5th Cir. 1981).
52. 904 F.2d at 990.
53. Id.
54. Id. at 991.
55. Id.
56. Id.
57. Id.
58. Id. at 992.
59. 15 U.S.C. § 78i(b) (1988).
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disclosure documents to customers before the broker-dealer accepts an
order for the purchase or sale of an option contract which is subject
to the disclosure requirement. 60 Plaintiffs alleged that Paine Webber
and Welch violated section 9 of the Securities Exchange Act by failing
to provide them with options disclosure documents. 61 The district court
held that "[m]ere failure to provide a disclosure document will not
establish liability or damage under section 9. Other elements such as
... [scienter] and the effect on market price also must be present."62
The Fifth Circuit held that the lower court correctly required the
plaintiffs to prove the effect of the manipulative practice on the
market. 63 In support, the Fifth Circuit cited its prior ruling in Chemetron Corp. v. Business Funds, Inc.,64 in which it had held that a
claim made under section 9(a) requires proof of effect on the purchase
price. 6S The Court extended this requirement to claims made under
section 9(b) and held that plaintiffs failed "to plead and prove a
necessary element of their section 9 claim."66
Other minor issues were addressed by the Fifth Circuit in Jolley.
The court upheld the district court's ruling that damages for mental
anguish resulting from securities churning are not recoverable under
Louisiana law. 67 The court also affirmed the lower court's ruling with
respect to unsuitability,68 admissible evidence,69 deferral to arbitration,70
60.
61.
62.
63.
64.
65.
66.
17 C.F.R. § 240.9b-l (1991).
904 F.2d at 992.
[d.
See id. at 993.
682 F.2d 1149 (5th Cir. 1982), cert. denied, 460 U.S. 1013 (1983).
[d. at 1164.
904 F.2d at 993.
67. See id. at 991. In order to recover damages for mental anguish under Louisiana law,
the distress must be caused by a non-pecuniary interest. See id. See also Stephenson v. Paine
Webber Jackson & Curtis, Inc., 839 F.2d 1095, 1101 (5th Cir.), cert. denied, 488 U.S. 926
(1988).
68. See 904 F.2d at 993.
69. See id. at 992. The court affirmed the trial court's ruling that a memorandum which
described irregularities found as a result of an audit of accounts handled by brokers was
inadmissible as cumulative and prejudicial because it described irregularities which occurred in
the accounts of persons unassociated with the lawsuit. [d.
70. See id. at 993-94. The court upheld the district court's refusal to refer a claim to
arbitration. noting that Paine Webber had declined to introduce a client option agreement into
evidence, so that the district court never had an opportunity to determine if the parties agreed
to arbitrate the issue. [d. at 994.
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and jury instructions with respect to the RICO claims. 7 •
IV. STATUTE OF LIMITATIONS FOR IOb-5 ACTIONS
In Lamp/, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson,72 the
United States Supreme Court held that an implied private cause of
action under sectionl0(b) of the Securities Exchange Act and Rule
IOb-5 73 is subject to a one year/three year statute of limitations: the
action must be brought within one year after discovery of facts which
constitute the violation and no later than three years after the violation. 74 The Court refused to borrow the two-year state statute of
limitations for fraud claims noting that "when the operation of the
state limitations period would frustrate the policies embraced by the
federal enactment," federal law may provide a more useful analogy. 75
The Court stated that:
[w]here, as here, the claim asserted is one implied under a statute
that also contains an express cause of action with its own time
limitation, a court should first look to the statute of origin to
ascertain the proper limitations period.... Only where no analogous counterpart is available should a court then proceed to apply
state-borrowing principles. 76
The Supreme Court sought guidance from sections 9(e) and 18
of the 1934 Act and section 13 of the 1933 Act which have one year/
three year limitation periods. 77 Section 9 of the 1934 Act, which relates
71. See id. at 991-92. The RICO interrogatories submitted to the jury included: "Do you
find by a preponderance of the evidence that [the defendants) violated the Racketeering [sic)
Influenced [and) Corrupt Organizations Act ...7" and "00 you find by a preponderance of
the evidence that [the defendants) violated Section 1O(b) of the Securities Exchange Act ... 7"
[d. at 991. The court found that the jury was not "confused into believing that the defendants
must be associated with organized crime." [d. at 992. Moreover, the court noted that "[a)ny
conf~sion in the charge between single acts of fraud furthered by multiple mailings and separate
mailings in furtherance of a scheme to defraud is minimal and does not render the instruction
as a whole inaccurate or confusing." [d.
72. 111 S. Ct. 2773 (1991).
73. 17 C.F.R. § 240.IOb-S (1991). Although section 1O(b) does not provide for private causes
of action, the United States Supreme Court has authorized implied private claims. See Blue Chip
Stamps v. Manor Drug Stores, 421 U.S. 723, 730 (l97S); Affiliated Ute Citizens v. United States,
406 U.S. 128, ISo-IS4 (1972); Superintendent of Ins. v. Bankers Life & Casualty Co., 404 U.S.
6, 13 n. 9 (1971). However, there is no statute of limitations period for implied claims under
section 1O(b) or Rule 10b-S. 17 C.F.R. § 240.10b-S.
74. III S. Ct. at 2782.
7S. [d. at 2778.
76. [d. at 2780.
77. [d. at 2780 nn. 6, 7. Sections 9(e) and 18(c) of the 1934 Act and section 13 of the 1933
Act contain slight variations of the one year/three year limitation. IS U.S.C. §§ 77m, 78i(e),
78r(c) (1988).
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to willful manipulation of security prices,'s and section 18, which
relates to misleading filings,79 are analogous because these are the same
dangers that section 1O(b) was designed to prevent. so Therefore, the
Supreme Court adopted those one year/three year limitation periods
for Rule lOb-S claims. s1
The Fifth Circuit decided In re Sioux, Ltd., Securities Litigation
v. Coopers & LybrantJ82 exactly nine months before the United States
Supreme Court ruled in Lampf that implied causes of action under
Rule lOb-S are subject to a one year/three year statute of limitations. s3
The plaintiffs in Sioux, Ltd. were subject to two changes in the statute
of limitations. First, in Williams v. Khalaf,84 the Texas Supreme Court
ruled that legislative changes lengthened the state statute of limitations
for common law fraud claims from two years to four years. S5 On
petition for rehearing of Sioux, Ltd., the Fifth Circuit held that the
four-year statute of limitations governs fraud claims,86 including Rule
lOb-S claims,87 and remanded the case for retrial on federal securities
law and state law fraud issues. 88 However, the court held that the
plaintiff's claim for negligent misrepresentation was governed by a
two-year statute of limitations, and therefore, was time-barred. 89
While the case was on remand on the common law fraud claims
and the Rule lOb-S claims, the United States Supreme Court decided
Lampf and applied a one year/three year limitation period for actions
brought under Rule lOb-S. 90 Several courts have applied the limitations
period adopted in Lampf retroactively to cases which were pending
when Lampf was decided. 91 Therefore, Sioux, Ltd. may face yet
another challenge based on this new statute of limitations.
78.
79.
80.
81.
82.
83.
84.
85.
86.
87.
88.
89.
90.
91.
Denver
15 U.S.C. § 78i (1988).
15 U.S.C. § 78r (1988).
III S. Ct. at 2781.
[d.
914 F.2d 61 (5th Cir. Sept. 1990).
Lampf, Pleva, Lipkind, Prupis & Pettigrow v. Gilbertson, III S. Ct. 2773, 2782 (1991).
802 S.W.2d 651 (Tex. 1990).
id. at 653-54.
See 914 F.2d at 64.
See id. See Longden v. Sunderman, 737 F. Supp. 968, 971-72 (N.D. Tex. 1990).
914 F.2d at 66.
See id. at 64.
Lampf, Pleva, Lipkind, Prupis & Pettigrow v. Gilbertson, 111 S. Ct. 2773, 2782 (1991).
See Anixter v. Home-Stake Prod. Co., 939 F.2d 1420, 1433 (10th Cir. 1991); Bank of
v. Southeastern Capital Group Inc., 770 F. Supp. 595, 596-97 (D. Col. 1991).
see
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In Sioux, Ltd., the Fifth Circuit held that the ormSSlon of the
word "fraud" in a footnote to a corporation's financial statements
which described litigation against the corporation for violation of
federal and state securities law was not a misrepresentation of material
fact. 92 The standard for determining whether a statement is material
is found in the oft-quoted' Supreme Court opinion, TSC Industries
Inc. v. Northway, Inc. :93 "An omitted fact is material if there is a
substantial likelihood that a reasonable shareholder would consider it
important in deciding how to vote."94 In Texas, courts have applied
a more stringent standar~: "Whether the contract would have' been
signed by the plaintiff without such misrepresentations having been
made."9s
The Fifth Circuit noted in Sioux, Ltd. that materiality is a mixed
question of fact and law which usually is decided by a jury.96 In order
to determine if the omission of the word "fraud" in the footnote was
material, the court analyzed the record to "determine whether a
reasonable jury could conclude on this record that a reasonable investor
would have considered the addition of the word 'fraud' in the audit
important in evaluating the risk" the corporation faced from the
lawsuit. 97 In making this determination, the court noted that when
plaintiffs read the footnote, they decided to hire a lawyer to investigate
the alleged fraud; plaintiffs investigated even in the absence of the
See 914 F.2d at 66.
426 U.S. 438 (1976) (setting forth the standard of materiality in a Rule 14a-9 claim).
94. [d. at 449. See also Basic, Inc. v. Levinson, 48S U.S. 224, 232 (1988); Isquith ex reI.
Isquith v. Middle South Uills., Inc., 847 F.2d 186, 207-08 (Sth Cir.), cert. denied, 488 U.S. 926
(1988) (in which the TSC standard has been applied to Rule 10b-S claims).
9S. Adikes v. Andreoli, 600 S.W.2d 939, 946 (Tex. Civ. App.-Houston [1st Dist.), 1980,
writ dism'd).
96. See 914 F.2d at 6S.
97. [d. at 66. Footnote 8 to the financial statement stated:
The company and two of its shareholders are named as defendants in a civil action
suit. The essence of the suit is a claim for damages relating to amounts alleged to be
due by virtue of a retained net profits interest in certain properties. The lawsuit makes
the claim pursuant to allegations that the defendants violated federal and state securities
laws.
92.
93.
••••• ••
[B)ased upon such investigation as has been completed at the present time, management
and legal counsel are of the opinion that it is more likely than not that the Plaintiffs
will not recover under any of their claims for damages and that the Plaintiffs will not
recover under their claims for recission and ownership.
[d. at 6S.
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word "fraud."98 Thus, the court concluded that the omission of the
word "fraud" from the financial statement was not a material misrepresentation since the plaintiffs would not have reacted· differently
if the word "fraud" had been included. 99
V.
NONDISCLOSURE OF ENTRENCHMENT DEVICES IN PROXY FIGHTS
In an effort to thwart a hostile take-over attempt by Sutherland
Lumber-Southwest, Inc., Justin Industries, Inc. adopted several shark
repellents and made a "scorched earth acquisition" of EI Paso bootmaker, Tony Lama Company.IOO Justin sued Sutherland, claiming that
Sutherland violated section 13(d) of the Securities Exchange Act of
1934110 by purchasing more than five percent of the target's stock
without filing a schedule 130. 102 Sutherland counterclaimed and alleged
that Justin deliberately refused to disclose in its proxy statements a
bylaw amendment which required a supermajority vote for the removal
of directors and failed to disclose golden parachutes for key managers
in violation of section 14(a) of the Securities Exchange Act of 1934103
and Rule 14a-9. 104
Sutherland petitioned the district court to set aside an uncontested
election which was won by the incumbent directors.l~ Sutherland also
requested the court to issue a preliminary injunction, directing Justin
to hold another election in which Sutherland nominees could campaign
against the incumbent directors. I06 The lower court refused to grant a
preliminary injunction because Sutherland had a legal remedy available. I07 As owner of more than ten percent of Justin's outstanding
stock, Sutherland could call a special shareholders' meeting to elect
new directors. lOS The court held that even if Sutherland did not have
98. [d. at 66. Based on this reaction, the Fifth Circuit concluded that a reasonable jury
could not have found that the addition of the word "fraud" to the footnote would have assisted
a reasonably prudent investor in assessing the fmancial risk involved. [d.
99.
[d.
100. Justin Acquisition of Tony LAma. Co., TExAs LAWYER, Dec. 10, 1990, at S.
101. IS U.S.C. § 78m(d) (1988).
102. Justin Indus., Inc. v. Choctaw Sec., L.P., 920 F.2d 262, 26S (Sth Cir. Dec. 1990).
103. IS U.S.C. § 78n(a) (1988).
104. 920 F.2d at 265; 17 C.F.R. § 24O.14a-9 (1991).
lOS. Justin Indus., Inc. v. Choctaw Sec., L.P., 747 F. Supp. 1218, 1220 (N.D. Tex. 1990),
qff'd. 920 F.2d 262 (Sth Cir. Dec. 1990).
106. [d.
107. See id. at 1221.
108.
[d.
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a self-help remedy, Justin's failure to disclose the bylaw amendments
was not a material omission. I09 In a per curiam decision issued in
Justin Industries, Inc. v. Choctaw Securities, L.P., tlO the Fifth Circuit
affirmed, and remanded the case for an expedited hearing on the
materiality of the omission. til
The Fifth Circuit affirmed the lower court's denial of the preliminary injunction because Sutherland had available the self-help remedy
of calling a special meeting to remove directors. tt2 Sutherland argued
that its self-help remedy was not as desirable as a new election. tt3 The
court determined that, in order for Sutherland to win at a special
meeting, it had to win a majority of outstanding shares, whereas in a
new election, Sutherland would only have to win a majority of all
shares present and voting. 114 The court noted that federal securities
laws are largely designed to protect shareholders, not corporate raiders. tiS The Fifth Circuit found that Sutherland had passed up its
opportunity to nominate a competing slate of directors although it
reasonably could have concluded, "even without knowledge of the
'secret' bylaw changes, that it should field a competing slate."tl6 The
court concluded that there was insufficient evidence of irreparable
harm because it was not clear that Sutherland's efforts to wage a
proxy fight were thwarted. tt7
The Fifth Circuit also addressed the materiality of the bylaw
changes. tl8 Rule 14a-9 forbids the. solicitation of shareholders by means
of a proxy statement which omits any material facts. tl9 Under the
standard for materiality enunciated in TSC Industries, Inc. v. Northway, Inc.,171) a plaintiff must show a "substantial likelihood that, under
[d. at 1223.
110. 920 F.2d 262 (5th Cir. Dec. 1990).
111. [d. at 269.
112. [d.
113. [d. at 268.
114. [d. The court noted that this "difference, which could change the result in a close
election, makes the remedy Sutherland seeks superior to the remedy that is available to it without
judicial relief." [d.
115. [d. at 269.
116. [d.
117. [d.
118. [d. at 266-68.
119. 17 C.F.R. § 240.14a-9(a) (1991).
120. 426 U.S. 438 (1976).
109.
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all the circumstances,. the omitted fact would have assumed actual
significance in the deliberations of the reasonable shareholder."121 In
TSC, the Supreme Court held that in determining materiality, the
"total mix" of information available must be evaluated. III In the
context of an omission in a proxy statement, the Fifth Circuit in
Justin held that materiality "is determined by taking into account all
information in the public domain and facts reasonably available to
the public to be used by shareholders in interpreting the information
in the proxy sent to them."123
The Fifth Circuit held that because Justin's board had made
known its opposition to a hostile takeover, average investors might
consider the bylaw changes to be material. l24 The court rejected the
district court's holding that "[t]he average shareholder does not have
enough time or interest to scrupulously monitor the affairs of each
corporation in which he invests. Decisions are made, often without
adequate information, let alone knowledge of the bylaws governing
the corporation."12s The Fifth Circuit indicated that the lower court's
ruling failed to adhere to the "clear intent of the securities laws to
foster informed investing based upon disclosed information."I26
The Fifth Circuit's holding recognized the important function of
corporate governance provisions, especially removal powers, through
which shareholders can maintain some control over the directors.
Noting that "[t]he removal power is an important check that a
shareholder has on the board,"127 the court held that the adoption of
shark repellents had the indicia of materiality.l28 The court also observed that "[t]he average investor probably would be interested to
know when directors facing a hostile takeover enact lucrative severance
contracts designed to entrench management,"129 and held that golden
121. [d. at 449.
122. [d.
123. 920 F.2d at 267 (quoting T. HAzEN, THE LAW OF SECURITIES REGULATION § 11.4 at 315
(2d ed. 1990» (footnote omitted).
124. [d. at 267.
125. [d. (quoting Justin Indus., Inc. v. Choctaw sec., L.P., 747 F. Supp. 1218, 1223 (N.D.
Tex. 1990».
126. [d. at 267-68. The Fifth Circuit also noted that the relevant test of materiality is defmed
by TSC, not by market reactions to the eventual disclosure of the amendments. [d. at 268 n.6.
127. [d. at 267.
128. [d. The court noted that striking "changes in that relationship [between shareholder and
director] bear a strong semblance of materiality." [d.
129. [d. at 268.
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parachutes may be material. 130 The court remanded the case to the
trial court to determine if the golden parachutes and shark repellents
were sufficiently part of the "total mix" of information available to
make the omission of such provisions material. 131 The court was
careful, however, to note that its ruling was limited to the specific
facts presented in the Justin takeover attempt, and that not all bylaw
changes are necessarily material. 132
VI.
WAIVER OF INTRASTATE EXEMPTION
Plaintiff, Dr. Windsor Dennis, sued several defendants after
investments he made turned sour. 133 The defendants included officers,
directors, and minority shareholders of two start-up corporations:
General Imaging, Inc. and New South Distributors, Inc. l34 In his
complaint, Dr. Dennis alleged violations of sections 12(1), 12(2), and
15 of the Securities Act of 1933,13S sections 10(b) and 20 of the
Securities Exchange Act of 1934,136 Rule lOb-5,137 and RIC0,138 The
district court granted defendants' motions for summary judgment with
respect to each of these alleged violations. 139
Dr. Dennis appealed, primarily with respect to the lower court's
decision that no violation of section 12(1) of the 1933 Act could be
found because the securities issued by General Imaging and New South
Distributors were exempt from registration under section 3(a)(11) of
the Act. l40 Under section 12(1), a seller of securities may be held liable
for failure to register securities which are subject to the 1933 Act's
registration requirements,141 However, if the security is exempt from
the registration requirements of the 1933 Act, no violation will occur.142
130.
131.
132.
133.
134.
135.
136.
137.
13R.
by the
139.
140.
141.
142.
[d.
[d. at 268.
See id. at 267.
Dennis v. General Imaging, Inc., 918 F.2d 496, 501-03 (5th Cir. Dec. 1990).
[d. at 500-01.
15 U.S.C. §§ 77e, 770 (1988).
15 U.S.C. §§ 78j(b), 78t (1988).
17 C.F.R. § 240.IOb-5 (1991).
918 F.2d at 501. Dr. Dennis also raised state law claims, which were summarily dismissed
lower court. [d. at 512.
[d. at 512.
[d. at 499.
15 U.S.C. §§ 77e, 77e(1) (1988).
15 U.S.C. § 77c(a) (1988).
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Although defendants did not raise the intrastate exemption of
section 3(a)(I1) of the 1933 Act or SEC Rule 147, the district court
found that the defendants met the requirements of the intrastate
exemption and the safe harbor provided by Rule 147"43 On appeal,
Dr. Dennis contended that the lower court erred by applying the
intrastate exemption to prevent liability under section 12(1) of the 1933
Act. l44 Dr. Dennis argued that the defendants had waived the defense
under Rule 8(c) of the Federal Rules of Civil Procedure. 145 The Fifth
Circuit rejected Dr. Dennis's restrictive interpretation of Rule 8(c) and
held that "[i]n the absence of unfair surprise, defendants did not
waive the defense by their failure to plead it in their answers."I46
Because the defendants raised the intrastate exemption in discovery
and in their motions for summary judgment, the court found that Dr.
Dennis was not a victim of surprise and no waiver occurred.147
On appeal, the defendants challenged the district court's ruling
that the jurisdictional requirement of section 12(1) had been met. 148 In
order to establish a violation of section 12(1), plaintiffs must prove
that the seller of securities used the United States mail or facilities of
interstate commerce in connection with the sale. l49 Dr. Dennis relied
on intrastate telephone calls to satisfy the jurisdictional requirements
of section 12(1).150 The district court found that the jurisdictional
requirement had been met and noted that "[i]t has long been held
that intrastate telephone Calls in which securities are promoted or
offered satisfies the jurisdictional provisions of the securities laws."I"
The defendants contended that the court erred because only interstate
telephone calls, not intrastate calls, meet the jurisdictional requirements
of section 12(1).152
The Fifth Circuit declined to rule on the district court's decision
that intrastate telephone calls could meet the applicable jurisdictional
requirements since. the defendants were not liable under section 12(1).153
143.
144.
145.
146.
1983».
147.
148.
149.
ISO.
lSI.
Dupuy
152.
153.
918 F.2d at 504.
[d. at 499.
[d.
[d. at 499-500 (citing Allied Chern. Corp. v. Mackay, 695 F.2d 854, 855-56 (5th Cir.
[d. at 500.
[d.
IS U.S.C. § 77e (1988).
918 F.2d at 500.
[d. at 504 n.9. (citing Loveridge v. Dreagoux, 678 F.2d 870, 874 (10th Cir. 1982»;
v. Dupuy, 511 F.2d 641, 642-44 (5th Cir. 1975), cert. denied, 434 U.S. 911 (1977».
[d. at 500.
[d.
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However, in dicta the court noted that although the district court's
conclusion was correct under the 1934 Act,lS4 the issue had not yet
been resolved under the 1933 Act. ISS Decisions issued with respect to
the 1934 Act "do not necessarily control the meaning of the jurisdictional requirements of section 12(1) of the 1933 Act."IS6
VII.
ATTORNEYS' FEES AWARDS IN SHAREHOLDER DERIVATIVE
ACTIONS
In O'Neill v. Church's Fried Chicken, Inc.,m the Fifth Circuit
ruled that a corporate shareholder in a derivative action was entitled
to recover attorneys' fees from the corporation· after its shares were
sold pursuant to a tender offer because the shareholder's efforts
conferred a substantial benefit on the corporation. ls8 Texas law allows
shareholders who· bring a successful derivative suit lS9 to recover their
attorneys' fees from the corporation if they establish that their efforts
conferred a substantial benefit on the corporation. l60 Relying on this,
the court dismissed the claim of the corporation's current owner that
the class representative's litigation activities did not provide it with
any benefit, but rather provided a benefit only to the corporation's
prior owners by causing an increase in the tender price paid by the
current owner. 161
In October of 1988, Biscuit Investments, Inc. announced a cash
tender for all of the outstanding shares of Church's Fried Chicken,
Inc., a publicly held corporation, at eight dollars per share. 162 After
[d.; 678 F.2d at 874; 511 F.2d at 642-44.
155. 918 F.2d at 500.
154.
156.
[d.
157. 910 F.2d 263 (5th Cir. Aug. 1990).
158. [d. at 265-67.
159. A derivative lawsuit is one brought by a stockholder to pursue a cause of action derived
from the corporation. See Cohen v. Beneficial Indus. Loan Corp., 337 U.S. 541, 549 (1949)
(Stockholder bringing a derivative action "assumes a position, not technically as a trustee perhaps,
but one of a fiduciary character."). Such a stockholder brings suit on behalf of himself, and as
the representative of all stockholders who are similarly situated. See id. The coun in O'Neill
noted in this regard that ..[s]tanding to pursue a derivative action requires that the proposed
plaintiff be a shareholder, that she adequately represent the interests of the shareholders, and
that she plead with particularity her efforts to have the suit brought for the corporation by the
board of directors." 910 F.2d at 265 n.5 (citing TEX. Bus. CORP. ACT ANN. an. 5.14 (8)
(Vernon 1980) and FED. R. av. P. 23.1).
160. See. e.g., Modern Optics, Inc. v. Buck, 336 S.W.2d 857, 861 (Tex. Civ. App.-Waco
1960, writ ref'd n.r.e.).
161. See 910 F.2d at 267.
162. [d. at 264, 264 n.1.
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considering the tender offer, which by its express terms would expire
on February 19, 1989, the board of directors of Church's Fried Chicken
concluded that the tender offer was not in the best interests of the
corporation's shareholders and recommended that they reject iLI63 The
board also sought to stall the takeover attempt by adopting a "poison
pill" device. 164 As a final matter, the board created a "golden parachute" providing generous severance benefits to sixteen senior executives in the event that the takeover bid was successful and resulted in
a change in control of the corporation. 16$
Shareholder Dixie J. O'Neill commenced litigation in November
of 1988, seeking to stop the effects of Church's Fried Chicken's
attempt to block Biscuit Investments' change-of-control tender offer" 66
Specifically, O'Neill asserted in her complaint that the directors' efforts
to fight the tender offer constituted an improper attempt at entrenchment, as well as a breach of their fiduciary duties of care and loyalty
to the corporation and its shareholders. 167 On this basis, O'Neill sought
affirmative injunctive relief providing for the acquisition of the corporation by way of the tender offer and attorneys' fees" 68 O'Neill
requested and received permission to proceed derivatively on behalf
of Church's Fried Chicken" 69
On December 28, 1988, O'Neill moved for a preliminary injunction requiring the directors to remove the poison pill that stood in the
way of Biscuit Investments' takeover attempt yo Thereafter, on January
18, 1989, the directors of Church's Fried Chicken announced their
decision that a sale of the corporation would be in the best interests
of the shareholders. 171 To accomplish the sale, the directors declared
a thirty-day auction of the corporation, to be concluded one day
[d. at 264.
[d. The poison pill offered each shareholder of record as of November 4, 1988 one
"right" for each share of common stock held by a shareholder. [d. at 264 n.2. The "right"
163.
164.
entitled the shareholder, inter alia, to purchase additional shares of Church's Fried Chicken stock
at greatly reduced prices upon the happening of specified triggering events. [d.
165. [d. at 264.
166. [d. at 264-65.
167. [d. at 264.
168. [d. at 265.
169. [d. at 264-65. O'Neill also requested certification to pursue the litigation as the class
representative of all the corporation's shareholders. [d. The court never considered O'Neill's
motion for class certification. Id. at 265 n.5.
170. [d. at 265:
171.
[d.
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before Biscuits Investments' tender offer expired on February 19,
1989. 172 O'Neill's lawsuit and her motion for a preliminary injunction
thus became moot issues l73 on February 15, 1989, when Biscuit Investments tendered a revised bid of eleven dollars per share and, in
response, the directors of Church's Fried Chicken approved the sale
at that price and eliminated the poison pill. 174 The change-of-control
tender was consummated on March 21, 1989, when Biscuit Investments
mailed payments directly to the shareholders of Church's Fried Chicken,
and the former directors of Church's Fried Chicken resigned. 17S
Just prior to the final consummation of the tender, O'Neill moved
the court for an award of her attorneys' fees and expenses. 176 The
trial court awarded O'Neill $412,477.71 for fees and expenses, concluding that she was entitled to such an award pursuant to the
substantial benefit rule embodied in Texas law. 177 The trial court
reasoned that although the February IS, 1989 decision of the directors
to approve the revised tender offer rendered moot O'Neill's derivative
action, Church's Fried Chicken failed to show that there was no causal
relationship between the derivative action and the decision of the
directors to approve the revised offer .178 The district court found,
therefore, that O'Neill's prosecution of the lawsuit affected the decision
of the. directors with respect to the revised offer, and that offer, with
its increased price per share, clearly "conferred a substantial benefit
upon Church's corporation and its shareholders. "179 The newly installed directors of Church's Fried Chicken then filed a notice of
appeal. 180
The Fifth Circuit affirmed the trial court's award of attorneys'
fees and costs 181 and rejected the arguments of Church's Fried Chicken
172. Id.
173. On February 9, 1989, the district court denied O'Neill's request for a preliminary
injunction mandating that the directors drop the poison pill. Id. Nonetheless, the court indicated
that it would grant injunctive relief to facilitate the sale of the corporation to the highest bidder
in the event that the directors failed to remove the poison pill by the close of the auction period
on February 18, 1989. See id.
174. Id.
175. Id.
176. Id.
177. Id. See supra text accompanying notes 157-60.
178. Id. at 265-66. The trial court explicitly borrowed this principle from Delaware law. Id.
at 266.
179. Id.
180. Id. at 264-65.
181. See id. at 267-68.
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that the trial court was clearly erroneous in finding that the increased
tender price conferred a substantial benefit on the corporation, as
opposed to the individual shareholders who accepted the offer or the
former owner of the corporation. l82 Although Church's Fried Chicken
argued that Biscuit Investments, the current owner of the corporation,
received no benefit from O'Neill's derivative action, but instead was
directly injured by the derivative action because it was forced to pay
a higher price to acquire the stock of the corporation, IS3. the Fifth
Circuit held that O'Neill's claim properly was characterized as a
derivative claim, one belonging to the corporation and thereby subjecting it to a claim for attorneys' fees and costS.I 84
The O'Neill court first observed that while the traditional "American Rule" generally precludes a successful litigant from collecting an
award of attorneys' fees from the losing partY,IS' equitable concepts
embodied in Texas law authorizes a shareholder who conducts a
successful derivative suit to recover attorneys' fees from the corporation upon a showing that the shareholder's efforts conferred a substantial benefit on the corporation. l86 The Fifth Circuit further observed,
however, that the trial court's award of fees and costs against the
corporation's new owners created an incongruity "with the traditional
purposes of the 'common benefit' rule, i.e., to shift the legal costs of
acquiring the common benefit to those who received it," 187 precisely
because O'Neill's derivative action did not benefit the new owners of
Church's Fried Chicken. l88 The court, nonetheless, found that the
182. [d. at 267. On appeal, Church's Fried Chicken did not claim that the trial court's award
was excessive, nor did it dispute that O'Neill's prosecution of the derivative action contributed
to the increased tender price. [d. at 266. Indeed, as the Fifth Circuit noted, Church's Fried
Chicken conceded that the increased sale price of the corporation's stock benefited shareholders
who chose to sell, and, further, that O'Neill's prosecution of the lawsuit justified an award of
fees and costs against the selling shareholders on the common benefit theory. [d.
183. [d. In short, Church's Fried Chicken claimed that it would be inequitable to force the
current owner of the corporation, Biscuit Investments, to pay for a benefit received by the
corporation's prior owners. [d.
184. Id. at 267.
185. [d. at 265 (citing A1yeska Pipeline Serv. Co. v. Wilderness Soc'y, 421 U.S. 240 (1975».
186. [d. See supra text accompanying note 158.
187. Id. at 266.
188. Id. The trial court relied upon Prudential-Bache Securities. Inc. v. Mathews, 627 F.
Supp. 622, 625 (S.D. Tex. 1986), for the proposition that a shareholder who brings a successful
derivative action is entitled to an award of attorneys' fees, notwithstanding that the stock tender
offer at issue resulted in new corporate ownership. See 910 F.2d al 266. The Fifth Circuit
expressly noted that Prudential-Bache neither discussed nor reconciled the incongruilY of requiring
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award was proper. 189
The focus of the court's analysis was the nature of O'Neill's
claim. Relying on Delaware law, the Fifth Circuit reasoned that
whenever a share purchase is inevitable, the duty of loyalty owed by
the directors to the shareholders changes from one of defending the
corporation to one of obtaining the best price for the shareholders. l90
The court further reasoned that misconduct on the part' of the directors
with respect to a tender offer harms all stockholders in proportion to
their share of corporate ownership. For that reason, the court concluded that a shareholder action in the nature of the action brought
by O'Neill must be pursued as a derivative action,191 and therefore,
by implication, the claim belongs to the corporation. l92 Because the
increased price per share of the revised tender offer accrued to the
benefit of all shareholders equally, in proportion to their share of
ownership, the Fifth Circuit held that the benefit of the derivative
action may be deemed to have accrued to Church's Fried Chicken,
which accordingly obligated it to pay the shareholders' attorneys'
fees. 193
new owners to pay attorneys' fees when the shareholder's derivative action resulted in a higher
acquisition price for the new owners with the purposes underlying the common benefit principlethat those who receive the benefit should pay for it. See id.
189. Id. at 267. In reaching this conclusion, the Fifth Circuit distinguished two cases cited
by Church's Fried Chicken to support its claim that it should not be required to pay O'Neill's
attorneys' fees. See id. at 266. The court determined thai Junker v. Crory, 650 F.2d 1349 (5th
Cir. 1981), and Christensen v. Kiewit-Murdock Investment Corp., 815 F.2d 206 (2d Cir.), cert.
denied, '484 U.S. 908 (1987), were not persuasive precedent because the shareholder actions in
those two cases could not be properly characterized as derivative actions. See id. al 266-67.
190. Id. at 267 (citing Revlon, Inc. v. MacAndrews'& Forbes Holdings, Inc., 506 A.2d 173,
182 (Del. 1985».
191. Id. (citing Moran v. Household Int'l, Inc., 490 A.2d 1059, 1069-71, afl'd, 500 A.2d
1346 (Del. 1985».
192. See id.
193. Id. The court admitted that its holding did not satisfactorily reconcile, in all respecls,
the incongruity of requiring new ownership to pay for a derivative action from which it did not
obtain any benefit. See id. The court was satisfied with both its analysis and its conclusion,
however, because it reasoned that the new owner of Church's Fried Chicken could have structured
its tender offer in such a way so as to shift the cost of fees to the shareholders receiving the
benefit. See id.
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