Fradkin v. Ernst

*832 MEMORANDUM OPINION and JUDGMENT ENTRY

This case involves a challenge to the implementation of the 1983 stock option plan (Plan) for the senior executives of Mohawk Rubber Company (Mohawk). The Plan was approved by Mohawk’s Directors on January 4, 1983, and presented to and allegedly approved by the shareholders at Mohawk’s Annual Meeting. Plaintiff contends that a proxy statement issued to shareholders describing the Plan prior to the Annual Meeting violated the federal securities laws. Plaintiff also argues that the Plan constitutes corporate waste and that the Plan was not approved by the requisite number of shareholders at Mohawk’s annual shareholder’s meeting.

I. PROCEDURAL HISTORY

Plaintiff filed the complaint in this case on March 25,1983. An amended complaint, raising class action and derivative claims, was filed on April 18, 1983 and is now the subject of this law suit. Count I of the amended complaint alleges violations of § 14(a) of the Securities Exchange Act of 1934 and SEC Rule 14a-9. Count II alleges a cause of action in common law corporate waste. Count III of the amended complaint seeks a declaratory judgment that the Plan was not approved pursuant to the terms of the Plan. Finally, Count IY of the Amended Complaint seeks a declaratory judgment that the Plan was not approved pursuant to Mohawk’s code of regulations.

The Court laid out the early procedural history of this case in its order denying the defendant’s motion to dismiss and granting plaintiff’s motion for class certification. 1

This case was tried to the Court from June 9,1983 through June 13,1983. At the close of the testimony, a briefing schedule was agreed to by the parties. Defendants further agreed to take no further action toward implementing the Plan pending the Court’s resolution of this lawsuit. Based upon the trial testimony and the exhibits introduced into evidence, the Court makes the following findings of fact and conclusions of law:

II. FINDINGS OF FACT

A. Parties.

Mohawk Rubber Company is an Ohio corporation with its principal offices in Hudson, Ohio. Mohawk’s principal business is the manufacture of tires sold in the replacement market for passenger cars and trucks. Mohawk also operates other diverse enterprises related to the rubber industry. During the last five years, Mohawk has experienced substantial financial success, in contrast to the losses being experienced by many of the larger tire companies. In 1982, Mohawk had net earnings of $8.8 million on net sales of over $214 million.

Mohawk’s stock is traded on the New York Stock Exchange. As of the record date for the 1983 annual meeting, there were 2,163,565 shares of Mohawk common stock outstanding divided among approximately 2600 shareholders. During 1982, Mohawk’s shares traded at prices ranging from $15 ¼ to $25 ⅛ per share. During the second quarter of 1983, the market price of Mohawk’s stock rose as high as $32 ¾ per share.

Because of Mohawk’s success and the relatively small portion of stock controlled by management, the investment community has viewed Mohawk as an ideal takeover candidate. During 1982, while Mohawk’s stock was trading for less than $25.00 per share, a number of investors considered Mohawk to be a profitable acquisition at prices as high as $32.00 per share. By December 1982, two separate investors had acquired significant blocks of Mohawk stock and filed Schedule 13D statements indicating that they sought to “seek out third parties who may be interested in acquiring the company.” Early in 1983, Independence Holding Co. (Independence) emerged as Mohawk’s principal suitor. In a schedule 13D filed on February 28, 1983, Independence *833 disclosed that it owned 16.04% of Mohawk’s common stock and was actively pursuing the possibility of forming some kind of combination with Mohawk.

In addition to these investors, senior Mohawk management received several expressions of interest from outside parties regarding an acquisition of Mohawk during 1982. Most of these expressions of interest involved leveraged buy-outs 2 of Mohawk, with senior management staying in control of the company and acquiring a substantial equity interest. Mohawk management considered the proposals but did not take any steps toward accepting and implementing any of these proposals.

Defendants Henry F. Fawcett and William T. Ernst are the principal executives of Mohawk. Fawcett has been an employee of Mohawk since 1946 and has held a variety of positions over the course of that career. Currently 63 years of age, Fawcett has been Chairman of the Board and chief executive officer of Mohawk since 1979 and owns approximately 2% of Mohawk’s outstanding common stock. William Ernst has also been employed by Mohawk since 1946. He has held various positions in the corporation and has been Mohawk’s president and chief operating officer since 1979. Currently 63 years of age, Ernst owns approximately .5% of Mohawk’s outstanding stock.

Mohawk’s Board of Directors, in addition to Fawcett and Ernst, includes five outside directors. .Those directors are Charles W. Enyart, a director of the company since 1935; C. Blake McDowell, Jr., a partner in a law firm which does a substantial amount of Mohawk’s legal work; Dr. Charles A. Sanders, the executive vice president of E.R. Squibb and Sons; Ralph T. Shipley, Fawcett’s brother-in-law and a former vice president of The Timken Company; and William B. Saxbe, a former United States Senator and Attorney General of the United States. As a group, the outside directors have significant personal and business ties to the corporation. In recent years, the Board assumed a relatively passive role in supervising the corporation’s conduct and frequently conducted its meetings informally.

The plaintiff in this case, Albert Fradkin, owns 1000 shares of Mohawk common stock. 3 Fradkin’s capacity to prosecute this lawsuit was the subject of a motion to dismiss filed by defendants. 4

B. Executive Compensation for Fawcett and Ernst.

During 1981, Fawcett and Ernst entered into lucrative long term employment agreements with Mohawk. The principal components of their compensation are a salary and a bonus based upon Mohawk’s earnings. Historically, Ernst has received an annual bonus representing approximately 3% of Mohawk’s earnings. Fawcett’s bonus represents approximately 5% of Mohawk’s earnings. For the year 1982, Fawcett and Ernst earned $607,125 and $444,608 respectively in salary and bonus. These employment agreements remain in effect, absent a termination for cause, for three years after notice of termination is given.

Fawcett and Ernst are covered by both Mohawk’s Pension Plan for Salaried Em *834 ployees and Mohawk’s Supplemental Retirement Income Plan. Under the terms of the Pension Plan, Fawcett is entitled to receive a lifetime annuity (ten years certain) in the amount of $189,469.00 annually. Ernst would receive the same annuity in the amount of $181,269.00 annually. Fawcett and Ernst will also receive benefits under Mohawk’s Supplemental Retirement Income Plan. These additional benefits are keyed to their salary and bonus during the five years preceding retirement and the consumer price index. If Fawcett and Ernst were to elect to receive these payments as life-time annuities 5 (ten years certain) beginning at age 65, the annual annuity to Fawcett would be $198,280.00 and to Ernst $142,552.00.

Since 1978, Fawcett and Ernst’s compensation has also included a stock option plan. Fawcett earned profits of $132,132.00, and Ernst $89,942.00 upon the surrender and cancellation of stock appreciation rights (SARs) 6 relating to stock options granted them between 1978 and 1982. A stock option plan approved by Mohawk’s Board of Directors in 1982 provided for an additional grant of stock options to Fawcett and Ernst, but limited the grant to stock valued at $100,000.00 per individual per calendar year. The Board terminated the 1982 Plan at the time it adopted the 1983 Plan.

C. Development of 1983 Stock Option Plan.

Mohawk’s Board of Directors discussed the adequacy of the compensation available to Fawcett and Ernst under the 1982 stock option plan at the October 1982 Board meeting. At that time, the directors, particularly Dr. Sanders, expressed the view that the 1982 Plan provided inadequate benefits to Fawcett and Ernst. No official action was taken, but Ernst was directed to give this subject further consideration. Dr. Sanders reiterated his views in a December 1982 letter to McDowell.

After the October 1982 meeting, Ernst began work on what became the 1983 stock option plan (Plan). In drafting the Plan, he coupled the Board’s desire for a more generous option plan with a mechanism for compensating Fawcett and himself in the event of a reorganization. This latter feature of the Plan, the reorganization premium, 7 originated with Ernst. The operation of the reorganization premium is discussed in the next section. The developing Plan went through a number of drafts in December 1982 and January 1983. Notably, the draft dated January 4, 1983, varies significantly from the Plan presented to the shareholders. 8

D. Terms of the 1983 Stock Option Plan.

The Plan provided for grants to Fawcett and Ernst of both options and SARs in tandem with options on 200,000 shares of Mohawk common stock with Fawcett to receive options on 120,000 shares and Ernst to receive options on 80,000 shares. In total, these proposed grants represent 9.25% *835 of Mohawk’s then outstanding common stock. Absent a change in control, and subject to the provisions of Exchange Act § 16(b) dealing with insider trading, this arrangement would allow Fawcett and Ernst to receive $200,000.00 for each dollar per share increase in the value of Mohawk’s common stock above the exercise price of the options.

Under the terms of the Plan, the exercise price of the options was keyed to the market price on the day of the grant. The value of the options, therefore, was tied to the market price of Mohawk’s shares on the day of the grant. As a result an increase in the market price of Mohawk shares prior to the grant would diminish the value of the options to Fawcett and Ernst.

The more complex provisions of the Plan related to the effect of a merger, consolidation, or other reorganization transaction 9 upon the granted options and SARs. Under the terms of the Plan, if any reorganization transaction took place, Fawcett and Ernst would be required to surrender all of their outstanding and unexercised options and SARs to the corporation. In exchange for that surrender, they would each receive, as the reorganization premium, a cash payment in an amount equal to the lesser of the per share consideration 10 (cap provision) or four times the difference between the per share consideration and the option price per share (multiplier provision).

The options were granted at $24,125 per share. The effect of setting the option price at this level was to place a “cap” on the option plan at $32,125 per share. 11 If a reorganization transaction should take place where the per share consideration was $32,125 per share or less, the multiplier provision of the option plan would control. If the per share consideration in a reorganization transaction were greater than $32,125, the capped provision would prevent the multiplier provision from applying.

The mechanics of the reorganization premium can be explained using a pair of examples. In the event that a reorganization transaction took place at a per share consideration of $32.00 per share, the options on the 200,000 shares held by Fawcett and Ernst would be worth $6.3 million. If the reorganization transaction took place at $35.00 per share, the options would be worth $7.0 million. The calculations involved in reaching these totals are set forth in the margin. 12

*836 Under the terms of the Plan, any options granted would be invalidated if the Plan failed to receive approval by the holders of the majority of the common stock present or represented and entitled to vote at the 1983 annual meeting. This approval requirement, which tracks the language of Exchange Act Rule 16b-3, 13 apparently was designed to qualify the Plan for the exemption to the short swing profit rules of § 16(b) of the Exchange Act.

E. Events of January 4, 1983.

On December 17, 1982, certain large shareholders of Mohawk filed an amended Schedule 13D indicating their intent to seek out other investors who might be interested in acquiring Mohawk. During the weeks that followed, the value of Mohawk’s stock rose steadily. Near the close of 1982, Mohawk’s stock stood at $25 ⅛ per share, its all time high. In Ernst’s own words, Mohawk’s stock “began a rapid run up of the price .... [W]e were concerned things might get out of hand.” Tr. at 869. 14

On January 4, 1983, sixteen days before the regularly scheduled Board of Directors meeting at which the Plan was to be presented, Ernst telephoned the Directors individually to obtain approval for the Plan. No prior written notice was given to the Directors, and the Plan was not before them in written form prior to the telephone calls. Throughout the day, Ernst called each Director individually and explained the Plan. At no time were all of the Directors on the phone at the same time, and only one call was placed to each Director.

During each conversation, Ernst explained the provisions of the Plan. The complete details of the Plan were not explained with all of the Directors. Ernst did not tell all of the Directors the number of options to be granted. Further, Shipley and Saxbe did not learn that there were SARs attached to the options. Also, Saxbe did not learn of the multiplier provision of the Plan until months later.

Each Director orally approved the Plan as described to him. However, the Plan that was ultimately presented to the shareholders was not in final form at the time of the January 4, 1983 phone calls. Most significantly, the capped provision to the calculations in the event of a reorganization transaction was not included in the draft of the Plan discussed on January 4, 1983.

During the phone calls, Saxbe, McDowell, and Sanders agreed to serve on the Option Committee. Their appointment to the Option Committee, however, was not discussed with the other Directors. 15 The *837 members of the Option Committee did not meet or speak with each other on January 4, 1983, nor did they take any action to grant options to Fawcett and Ernst on January 4, 1983.

Sometime after January 4, 1983, minutes of the “Board of Directors Meeting” and “Option Committee Meeting” were prepared. Those minutes outline the events of January 4, 1983, as if they had taken place in formal meetings. The minutes describe motions being made and seconded and debate taking place. While the minutes may describe the intent of the directors, they constitute a fictionalization of what might have happened had actual meetings taken place. The events of January 4, 1983, contained none of the procedures of a regular, formal meeting. To the extent, therefore, that the minutes suggest that a meeting took place in which regular procedures were followed, the minutes are inaccurate.

F. Signing of the Option Agreements.

Pursuant to the Plan, option agreements were prepared between Fawcett and Ernst and Mohawk. Those agreements state that they were signed by Fawcett, Ernst, and the members of the Option Committee on January 4,1983. In fact, those agreements were signed at the January 20, 1983, regular meeting of the Mohawk Board of Directors. The Plan was not discussed at the January 20, 1983 Board meeting.

G. Proxy statement.

On March 7,1983, Mohawk sent its shareholders a notice and proxy statement for the Annual Meeting of Shareholders scheduled for April 12, 1983. The proxy statement indicated that the two principal items of business scheduled to come before the meeting were a proposal to re-elect Ernst, McDowell and Saxbe as Directors and a proposal to adopt the Plan. In a letter to Mohawk’s shareholders which accompanied the proxy statement, Fawcett and Ernst urged the shareholders to give prompt attention to the proxy and indicated that the Board of Directors unanimously recommended a vote for the Plan.

The proxy statement also contained a lengthy description of the Plan. The full text of that description is set out as appendix A of this opinion. In addition, the full text of the Plan itself was appended as an exhibit to the proxy statement.

H. Events leading to preparation of a supplemental proxy statement.

On March 17,1983, representatives of Independence met with Fawcett and Ernst to discuss the Plan and the proxy statement, along with Independence’s efforts to obtain a seat on Mohawk’s Board of Directors. At that meeting, Independence’s representatives advised Fawcett and Ernst that they viewed the proxy statement as misleading because of its failure to fully disclose all of the benefits payable to Fawcett and Ernst. On March 22, 1983, Independence filed an amendment to its Schedule 13D which stated that Independence did not intend to support the adoption of the Plan because the benefits payable under the Plan were “excessive.” Independence further stated that it believed the Plan was not in the best interests of the corporation.

Subsequently, on March 25, 1983, this action was commenced. Plaintiff filed a verified complaint in this Court seeking, among other things, a preliminary and permanent injunction barring the submission of the Plan to a shareholders’ vote at Mohawk’s annual meeting. On March 30,1983, Judge John Manos of this Court entered an Order allowing the vote to go forward, but enjoining Mohawk from taking any steps toward implementing the Plan pending a trial on the merits.

I. Supplemental proxy statement.

On April 2, 1983, ten days before the annual meeting, Mohawk issued a supplemental proxy statement. The statement addressed many of the issues raised by Independence’s objections and this law suit. The full text of the supplemental proxy statement is set out as appendix B of this opinion. In any case, defendants do not rely on the disclosures contained in the supplemental proxy in the defense to plaintiff’s cause of action.

At the time of the mailing of the supplemental proxy statement, proxies represent *838 ing 855,099 shares (39.5%) of Mohawk’s outstanding common stock had already been received. Of those shares, 780,177 had voted in favor of the Plan, 61,791 had voted against the Plan, and 13,131 had abstained. The supplemental proxy statement was not mailed to any of these shareholders.

The supplemental proxy statement was sent to the remaining 1,187 record holders of Mohawk common stock, representing I, 308,466 (60.5%) shares. With respect to shares held by brokers in “street name,” 16 for the beneficial owners, the supplemental proxy statement was mailed too late to allow the brokers to mail the statement to the beneficial owners of the shares before the annual meeting. A substantial number of Mohawk shareholders, including Saxbe and Sanders, never received the supplemental proxy statement.

J. Annual meeting of April 12, 1983.

On April 12, 1983, Mohawk’s annual meeting of shareholders was held. Holders of 1,821,113 shares (84.17%) of Mohawk common stock were represented at the meeting for quorum purposes. The election of directors was held in accordance with a demand for cumulative voting. F. Peter Zoch, III, Independence’s President, was elected to Mohawk’s Board of Directors along with Ernst and McDowell. Saxbe was not reelected.

With respect to the vote on the Plan, proxies representing 312,321 shares were not voted. These were shares held in street name by brokers for the beneficial owners of the shares. Pursuant to New York Stock Exchange rules, the brokers, who had not received specific instructions from the beneficial owners of the shares with regard to voting on the Plan, were unauthorized to cast votes on the Plan. 17 Many of the brokers physically struck the proposal relating to the Plan from the proxy or otherwise indicated that they were not entitled to vote on that proposition.

In the vote on the Plan, the shares were voted as follows:

No. of Shares Voted

For the Plan 807,661

Against the Plan 679,160

Abstained 20,457

Street Names 312,321

Absentees 343,996

Total Outstanding Shares 2,163,565

The parties dispute whether the absentee and street names shares should be considered in determining whether this distribution of shares represents majority approval of the Plan. The following percentages are obtained for each of the potential permutations:

*839 [[Image here]]

For the Plan 37.33% 43.63% 44.39% 53.58%

Against the Plan 31.39 36.69 37.32 45.06

Abstained 0.94 1.11 1.12 1.36

Street Names 14.44 XX 17.17 XX

Absentees 15.90 18.57 XX XX

100.00% 100.00% 100.00% 100.00%

Shares

Considered 2,163,565 1,851,244 1,819,599 1,507,278

The inspector of elections certified the results of the election and signed a certificate indicating that the Plan was duly approved. 18

K. Events following the annual meeting.

At the May, 1983, meeting of the Board of Directors, Fawcett and Ernst presented a document entitled “Approval of Directors of the Mohawk Rubber Company to Action Without a Meeting” to the Directors. The document, which was designed to cure the Board’s failure to have a formal meeting on January 4, 1983, was signed by all of the pre-annual meeting directors, including Saxbe. 19 The new Director, F. Peter Zoch, III, did not sign the document. A similar document entitled “Approval of Option Committee of the Directors of the Mohawk Rubber Company to Action Without a Meeting” was also signed by Sanders, McDowell and Saxbe on or about May 19, 1983. That document was designed to cure the failure of the Option Committee to hold a formal meeting on January 4, 1983.

III. DISCUSSION

Jurisdiction in this case is not in dispute. Federal district courts have exclusive jurisdiction for violations of the securities laws. Exchange Act § 27. The private right of action for violations of § 14(a) of the Securities Act was recognized by the Supreme Court in J.I. Case Company v. Borak, 377 U.S. 426, 84 S.Ct. 1555, 12 L.Ed.2d 423 (1964). The remaining state law claims are properly before the Court under this Court’s pendant jurisdiction because they arise out of the same nucleus of operative facts as the federal securities action. Personal jurisdiction and venue are proper in this Court because Mohawk has its principal place of business within the Northern District of Ohio.

This action is properly maintainable as a shareholder’s derivative action and as a class action. Fradkin was a Mohawk shareholder at the time all of the relevant events in this litigation took place. The action was not brought collusively to confer jurisdiction upon the Court. Although plaintiff made no demand on Mohawk’s Board to commence this action, such a demand would have been futile. 20 See Leff v. CIP Corp., *840 540 F.Supp. 857, 868-69 (S.D.Ohio 1982). The Court’s analysis of the remaining requirements for maintaining this suit as a class action and as a shareholders’ derivative action is set forth in this Court’s earlier order.

The Court will now turn to the four counts set forth in plaintiff’s amended complaint. The Court will begin its analysis with a consideration of the counts seeking a declaratory judgment that the Plan was not approved at the Annual Meeting. The Court will next turn to the count alleging that the proxy statement violated § 14(a) of the Exchange Act and Exchange Act Rule 14a-9. In light of the Court’s analysis of these counts, the Court need not reach the corporate waste count of the complaint.

A. APPROVAL OF THE PLAN.

As a threshold matter, the Court must consider whether the Plan was approved by the shareholders’ vote at the annual meeting. The parties do not dispute the final vote totals from the meeting. The parties dispute, however, the applicable standard for determining whether such a vote represents approval of the Plan.

Two separate standards must be considered — the terms called for by the Plan and Mohawk’s Code of Regulations. By its terms, the Plan states that it will terminate if it is “not approved by the holders of the majority of the common stock of the Company present, or represented, and entitled to vote at said annual meeting....” This standard tracks the language of Exchange Act Rule 16b-3, 21 the exemption from the short-swing liability provisions of § 16(b). Article I, section 6 of Mohawk’s Code of Regulations, however, provides that:

Any contract, act, or transaction, prospective or past, of the company, or of the Board, or of the officers may be approved or ratified by the affirmative vote at a meeting of the shareholders, or by written consent, with or without a meeting, of the holders of shares entitling them to exercise the majority of the voting power of the company, and such approval or ratification shall be as valid and binding as though affirmatively voted for or consented to by every shareholder of the company.

Plaintiff contends that the Plan failed to receive the required approval under both of these standards.

The parties agree that 807,661 shares voted for the Plan. They disagree, however, regarding the number of shares which should be included in the applicable pool of outstanding shares for purposes of determining whether this vote represents majority approval. The dispute focuses on whether shares not present at the meeting or held in street name should be considered in this pool. Given the vote totals at the meeting, both the absentee and street name shares must be excluded from the pool in order for the Plan to have received a majority affirmative vote. The Court will address these two classes of shares in the context of each of the applicable standards.

1. Majority standard in the Plan.

Under the terms of the Plan, approval is required of a majority of the stock “present, or represented, and entitled to vote.” Under the language of this provision, shareholders who did not submit proxies are not included in the pool because they were not “present” at the meeting. Further, the shares held in street names were ineligible to vote on the Plan and must also be excluded from the pool. Under this analysis, the Plan received 53.58% of the shares present and eligible to vote. There *841 fore, the Plan was approved by the shareholders under the terms specified by the Plan.

2. Majority provision of the Code of Regulations.

Pursuant to Article I, section 6 of Mohawk’s Code of Regulations, an act of the Board of Directors “may be approved or ratified by the affirmative vote ... of the holders of shares entitling them to exercise a majority of the voting power of the company .... ” Two disputes regarding the construction of this provision separate the parties. Again, the parties dispute the appropriate number of shares to be included in the pool of outstanding shares. The parties also dispute the construction of the word “may.”

Upon review of the language contained in the Code of Regulations, the Court concludes that those shares eligible to vote, but not present at the meeting, cannot be excluded from the pool. The Code of Regulations speaks in terms of voting power of the corporation; it makes no reference to a shareholder’s presence at the meeting. Accordingly, the Court concludes that the Plan received an affirmative vote of no more than 43.63% of the pool, and therefore, the Plan failed to receive a majority affirmative vote. 22

Defendants attempt to avoid this conclusion by arguing that the import of the word “may” in the Code of Regulations is permissive, not mandatory. According to defendants, the Code of Regulations allows the defendants to set a different standard for approval of the Plan. However, Article I, section 6 of the Code of Regulations begins with the phrase “Except as otherwise provided by the amended articles of incorporation or by law.” Given this limitation, the corporation may not change the majority vote requirement set forth in the Code of Regulations without amending the Code of Regulations or the Articles of Incorporation. Defendants’ argument, therefore, is not well taken. 23

The Court, therefore, concludes that the Plan did not receive the requisite majority affirmative vote required by Mohawk’s Code of Regulations. As the provisions of the Code of Regulations control the conduct of the corporation, the Court concludes that the Plan was not approved by the shareholders. Accordingly, the Court grants declaratory judgment for the plaintiff and against defendants on plaintiff’s claim that the Plan was not approved under the provisions of the Code of Regulations.

B. VIOLATIONS OF EXCHANGE ACT § 14(a) AND EXCHANGE ACT RULE 14a-9.

Plaintiff contends that Mohawk’s March 1983 proxy statement was materially misleading in violation of the laws regulating the solicitation of proxies. In relevant part, § 14(a) of the Exchange Act provides:

It shall be unlawful for any person, ... in contravention of such rules and regulations as the commission may prescribe as necessary or appropriate in the public interest or for the protection of investors, to solicit ... any proxy....

Because § 14(a) does not, by itself, proscribe any conduct, but solely serves to delegate that authority to the SEC, it is the SEC rules which set the applicable legal standard in this area. Pursuant to the authority granted in § 14(a), the SEC has promulgated Exchange Act Rule 14a-9. In relevant part, that rule provides:

*842 No solicitation ... shall be made by means of any proxy statement ... containing any statement which, at the time and in light of the circumstances under which it was made, is false or misleading with respect to any material fact, or which omits to state any material fact necessary in order to make the statements therein not false or misleading

Over the years, the Supreme Court has adopted a liberal interpretation of both of these provisions in order to implement the broad remedial purposes of the Exchange Act. See TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 444, 96 S.Ct. 2126, 2130, 48 L.Ed.2d 757 (1976); Mills v. Electric Auto-Lite Co., 396 U.S. 375, 381, 90 S.Ct. 616, 620, 24 L.Ed.2d 593 (1970).

Three separate legal issues are raised by plaintiff’s cause of action under Rule 14a-9. In considering the plaintiff's cause of action under Rule 14a-9, it is necessary to address the separate questions of causation, the applicability, if any, of a scienter requirement, and the standard for determining whether any misstatements or omissions in a proxy statement are sufficiently “material” to constitute a 14a-9 violation.

1. Causation.

The causation requirement in a 14a-9 action was discussed by the Supreme Court in Mills v. Electric Auto-Lite Co., 396 U.S. 375, 90 S.Ct. 616, 24 L.Ed.2d 593 (1970). In that case, the Court reversed a Seventh Circuit Court of Appeals decision which required a plaintiff to demonstrate that a defect in the proxy statement actually had a decisive effect on the voting. Instead, the Court ruled that:

Where there has been a finding of materiality, shareholder has made a sufficient showing of causal relationships between the violation and the injury for which he seeks redress if, as here, he proves that the proxy solicitation itself, rather than the particular defect in the solicitation materials, was an essential link in the accomplishment of the transaction.

Id. at 384-85, 24 90 S.Ct. at 622. In this case, the plan, by its terms, required shareholder approval. The solicitation of proxies, therefore, was “an essential link in the accomplishment of the transaction.” Accordingly, if the proxy statement contains a material misstatement or omission, the causation requirement is met.

2. Scienter requirement.

Defendants argue that plaintiff must show that they acted with scienter in order to prove their claim under Rule 14a-9. While the Supreme Court has imposed a scienter requirement in the context of the private right of action under Rule 10b-5, Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976), the issue remains unresolved in the context of the Rule 14a-9 cause of action. 25

The leading case on the scienter requirement in a 14a-9 action brought against a corporate defendant is Gerstle v. GambleSkogmo, Inc., 478 F.2d 1281 (2d Cir.1973). The Court relied on the differences between the statutory authorization for Rules 10b-5 and 14a-9 to suggest that the scienter requirement under Rule 10b-5 need not be extended to Rule 14a-9. Id. at 1298-99. Further, the Court found that general principles of tort law indicated that where “the transaction redounded directly to the benefit of the defendant, ... the common law *843 would provide the remedies of rescission and restitution without proof of scienter.” Id. at 1300. Further, the Court concluded that “a broad standard of culpability ... will serve to reinforce the high duty of care owed by a controlling corporation to minority shareholders in the preparation of a proxy statement .... ” Id. The Court, therefore, held that when the plaintiffs “are seeking compensation from the beneficiary who is responsible for the preparation of the [proxy] statement, they are not required to establish any evil motive or even reckless disregard of the facts. Id. 478 F.2d at 1300-01. Liability would be imposed upon individuals who “merely negligently drafted” a proxy statement. Id. at 1301 n. 20

The Sixth Circuit addressed the issue of a Rule 14a-9 scienter requirement in a slightly different context in Adams v. Standard Knitting Mills, Inc., 623 F.2d 422 (6th Cir.1980). In that case, the Sixth Circuit reversed a judgment assessing damages against a firm of certified public accountants for the negligent preparation of a proxy statement used to obtain shareholder approval of a merger. In that case, the Court concluded that “scienter should be an element of liability in private suits under the proxy provisions as they apply to outside accountants.” 623 F.2d at 428. The Court distinguished the scienter requirements for outside accountants and corporate issuers. Id. at 428. Reviewing the legislative history of the Exchange Act, the Court found that the principal concern of the drafters of the proxy rules was that of “corporate officers using the proxy mechanism to ratify their own frauds upon the shareholders.” Id. at 429. The critical distinction, therefore, is that

the accountant here, unlike the corporate issuer, does not directly benefit from the proxy vote and is not in privity with the stockholder.... Federal courts ... have a special responsibility to consider the consequences of their rulings and to mold liability fairly to reflect the circumstances of the parties.... The preparation of financial statements to be appended to proxies and to other reports is the daily fare of accountants, and the accountant’s potential liability for relatively minor mistakes would be enormous under a negligence standard.

Id. at 428. The Court, therefore, distinguishing between outside accountants and the corporate issuer, imposed a scienter requirement in a private action brought under Rule 14a-9 against outside accountants.

In light of these authorities, the Court must now consider the applicability of a scienter requirement to the corporate issuer under Rule 14a-9. While the leading cases apply a negligence standard to corporate insiders, the Sixth Circuit has imposed a scienter requirement for finding outside accountants liable under Rule 14a-9. The issue, therefore, is whether the Court should distinguish between the scienter requirement imposed in the context of corporate issuers and outside accountants under Rule 14a-9 or whether the Court should extend the scienter requirement for outside accountants developed in Adams to a case involving a corporate issuer.

Upon review, the Court concludes that a distinction between the liability of a corporate issuer and outside accountants is appropriate, and a negligence standard should apply to the corporation issuing the proxy statement. Where the Gerstle court concluded that a negligence standard would be appropriate where the “transaction redounded directly to the benefit of the defendant,” 478 F.2d at 1300, the Adams court imposed a scienter requirement where the outside accountant “does not directly benefit from the proxy vote,” 623 F.2d at 428. In the Court’s view, these two precedents are harmonious. Where the defendant is the corporate issuer, and the corporate officials are responsible for drafting the proxy statement, the Gerstle negligence standard applies, but not the Adams scienter requirement. As a matter of law, the preparation of a proxy statement by corporate insiders