Kennedy, John P. v. Venrock Associates

In the
United States Court of Appeals
For the Seventh Circuit
____________
No. 02-4330
JOHN P. KENNEDY, et al.,
Plaintiffs-Appellants,
v.
VENROCK ASSOCIATES, et al.,
Defendants-Appellees.
____________
Appeal from the United States District Court
for the Northern District of Illinois, Eastern Division.
No. 02 C 383—James F. Holderman, Judge.
____________
ARGUED MAY 27, 2003—DECIDED OCTOBER 29, 2003
____________
Before BAUER, POSNER, and COFFEY, Circuit Judges.
POSNER, Circuit Judge. This is a suit by common sharehold-
ers of Cadant, Inc. (now CDX Corporation). The defendants
are two corporate entities that we’ll call “Venrock” and “J.P.
Morgan” and individuals associated with them, but we
defer consideration of the individual defendants to the end
of the opinion and till then use “defendants” to denote just
the entities. The suit is based on federal securities law and
state antifraud law. It charges the defendants, though they
are not affiliated with each other (an important point to
stress, because throughout the plaintiffs’ briefs the defen-
dants are lumped together under the name, coined by the
plaintiffs’ lawyers, “Venrock Affiliates,” which is not to be
2 No. 02-4330
confused with “Venrock Associates,” the name of one of the
defendants), with having acted “in virtual tandem” to seize
control of and plunder Cadant. In doing so they are alleged
to have violated the fiduciary duty that they owed the
plaintiffs by virtue of having obtained control of the corpo-
ration. The plaintiffs, who own roughly a quarter of the
company’s common stock, seek $100 million in damages.
Cadant is in bankruptcy, and the district judge dismissed
the complaint on the ground that the plaintiffs’ claims,
though styled as individual (“direct”) claims, really are de-
rivative claims and thus belong to Cadant. If so, they must
be litigated in the bankruptcy court—where the plaintiffs
and the other shareholders would have to share any liqui-
dation value with Cadant’s creditors, who happen to
include the defendants.
We construe the facts as favorably to the plaintiffs as the
record, which is limited to the 123-page complaint and the
exhibits attached to it, permits, while of course not vouching
for the accuracy of the allegations. Cadant was formed in
1998 by Venkata Majeti and others to develop cable modem
termination systems, which enable high-speed Internet
access to home computers. Though based in Illinois,
the company was incorporated in Maryland. Majeti and the
other founders received common stock in the new corpora-
tion at the outset. The company issued additional stock
the next year to the plaintiffs for $7-$8 million (the exact
amount is not in the record). The year after that the com-
pany issued the defendants preferred stock for $12 million;
others received preferred stock as well, but between them
the defendants received and still own 90 percent of it.
A principal of Venrock, named Copeland, became a member
of Cadant’s five-member board of directors. The other four
board members, however, had no affiliation with either
Venrock or J.P. Morgan. The plaintiffs irresponsibly contend
No. 02-4330 3
that one of the four, a Mr. Rochkind, though unaffiliated
with either Venrock or J.P. Morgan, owned some of the
preferred stock in Cadant and was therefore “aligned” with
the defendants.
The following year, 2000, the board turned down a ten-
tative offer by ADC Telecommunications to buy Cadant for
some $300 million. Later that year the board proposed and
the shareholders approved the reincorporation of Cadant in
Delaware, which provides less protection to minority
shareholders than Maryland does.
By the beginning of 2001, Cadant, like many other start-up
companies in Internet-related businesses, was in deep
financial trouble. The defendants—having spurned more
favorable financing possibilities for Cadant (the leitmotif of
this suit is that the defendants, although controlling the
company, repeatedly missed chances to sell or finance it that
would have saved it from insolvency)—agreed with each
other and with the board of directors to make Cadant an $11
million bridge loan. (A bridge loan is a short-term loan to
tide the borrower over while he seeks longer-term financ-
ing.) The loan was for 90 days at an annual interest rate of
10 percent and also gave the lenders warrants (never
exercised) that they could use to purchase common stock.
The terms were highly favorable to the lenders.
Only about 60 percent of the $11 million loan was lent
by the defendants. The other owners of preferred stock were
eligible to participate in the loan, including the director who
though not affiliated with either Venrock or J.P. Morgan
owned some of that stock. It is unclear whether he partici-
pated in the loan, but probably he did because the board
voted him some options to buy common stock in Cadant.
Shortly before the bridge loan was made, a representative
of J.P. Morgan had been added to Cadant’s board, raising
4 No. 02-4330
the number of directors to six. And earlier, in September,
one of the independent directors had been replaced by an
employee of J.P. Morgan named Lyon, so that half the board
was now controlled by the defendants. Shortly afterwards,
still another representative of the defendants was added to
the board, so that between them the defendants at last
controlled a majority of the board’s members (four out of
seven). But this lasted only until March (2001), by which
time Lyon had resigned from J.P. Morgan (the exact date of
his resignation is unclear).
Within a couple of months of receiving the bridge loan,
Cadant had run through the entire $11 million. In May the
defendants arranged for a second bridge loan, this one for
$9 million, which gave the lenders (who again included the
defendants) a preference in the event that Cadant was sold
or otherwise liquidated: they would be entitled to “an
amount equal to 200% of (i) outstanding principal amount
of the Loans plus (ii) any accrued but unpaid interest there-
on.” (On liquidation preferences generally, see Don Clark &
Lisa Bransten, “E-Business: Starting Gate,” Wall St. J., Mar.
19, 2001, at B6; Colin Blaydon & Michael Horvath, “Liqui-
dation Preferences: What You May Not Know,” Venture
Capital J., Mar. 1, 2002, p. 45; see also Ravi Chiruvolu, “It
May Be Time to Hit the Reset Button on Liquidation
Preferences,” Venture Capital J., July 2002, p. 28. Of course a
“liquidation preference” of sorts is implicit in the status of
a lender or a preferred shareholder, since both have priority
over common shareholders.) The first loan was then
amended to add a (smaller) liquidation preference. The
defendants discouraged a search for alternative financing on
terms that would have been more favorable to Cadant,
because they wanted to suck out Cadant’s assets by means
of the liquidation preferences.
Cadant defaulted on the second bridge loan. The lenders
did not foreclose. Instead Cadant sold its entire assets to a
No. 02-4330 5
firm called Arris Group in exchange for stock worth at the
time of the sale (January 2002) some $55 million, an amount
just large enough to satisfy the claims of Cadant’s creditors
and preferred shareholders. The board turned down alter-
natives that would have been better for Cadant but worse
for the defendants, who remember were preferred share-
holders but also creditors by virtue of the bridge loans. The
sale to Arris was approved by Cadant’s board and also, as
required by Delaware law and the articles of incorporation,
by a simple majority of Cadant’s common and preferred
shareholders voting together as a single class and a simple
majority of the preferred shareholders voting separately.
Approval by two-thirds of “of all the votes entitled to be
cast on the matter” would have been required had Mary-
land rather than Delaware corporation law governed
Cadant, as it had done originally. Md. Code Ann., Corpora-
tions & Associations § 3-105(e). For while Maryland permits
a corporation to opt out of the two-thirds requirement, id.,
§ 2-104(b)(5), Cadant had not done so. The record is silent
on whose votes were “entitled to be cast on the matter” (just
common shareholders, or preferred shareholders as well?),
so we do not know the exact change in shareholders’ rights
that was brought about by the reincorporation.
The Arris stock became the property of the bankrupt
estate. But because its price has since fallen by 60 percent
(and it is Cadant’s only asset), the estate is now worth even
less than the claims of the bridge lenders and other cred-
itors; and so the plaintiffs and the other shareholders, in-
cluding the defendants in their capacity as owners of
preferred stock in Cadant, stand to lose their entire invest-
ment. The plaintiffs argue that by becoming creditors the
defendants wrongfully appropriated Cadant’s value.
When a corporation is injured by a wrongful act but the
board of directors refuses to seek legal relief, a shareholder
6 No. 02-4330
can sue the wrongdoer on behalf of the corporation. Alabama
By-Products Corp. v. Cede & Co., 657 A.2d 254, 265 (Del.
1995); Rales v. Blasband, 634 A.2d 927, 932 (Del. 1993); Kamen
v. Kemper Financial Services, Inc., 500 U.S. 90, 95-96 (1991); In
re Abbott Laboratories Derivative Shareholders Litigation, 325
F.3d 795, 803-04 (7th Cir. 2003); Fogel v. Zell, 221 F.3d 955,
965 (7th Cir. 2000); Stepak v. Addison, 20 F.3d 398, 402 (11th
Cir. 1994); see also Parnes v. Bally Entertainment Corp., 722
A.2d 1243, 1245 (Del. 1999). Such a suit is known as a
derivative suit, and is an asset of the corporation— which
means that if, as in this case, the corporation is in bank-
ruptcy, the suit is an asset of the bankrupt estate. 11 U.S.C.
§ 541(a)(1); Pepper v. Litton, 308 U.S. 295, 306-07 (1939); Koch
Refining v. Farmers Union Central Exchange, Inc., 831 F.2d
1339, 1343-44 (7th Cir. 1987); In re Ionosphere Clubs, Inc., 17
F.3d 600, 604 (2d Cir. 1994). As common shareholders of a
bankrupt corporation, the plaintiffs very much do not want
to be in bankruptcy court, where they would be entitled to
nothing until all other claimants to the corporation’s assets
were paid in full, and so they claim to have individual
rather than derivative claims against the defendants, the
alleged wrongdoers.
They seek to fit their case into the familiar framework of
a suit by a minority shareholder against a majority share-
holder. The latter has a fiduciary obligation to the former.
Kahn v. Lynch Communication Systems, Inc, 638 A.2d 1110,
1113-14 (Del. 1994); In re MAXXAM, Inc., 659 A.2d 760,
771 (Del. Ch. 1995); Southern Pacific Co. v. Bogert, 250 U.S.
483, 487-88 (1919); Pepper v. Litton, supra, 308 U.S. at 306-07;
In re Lifschultz Fast Freight, 132 F.3d 339, 344 n. 2 (7th Cir.
1997); Rademeyer v. Farris, 284 F.3d 833, 837 (8th Cir. 2002).
The breach of that obligation is a wrong to the minority
shareholder rather than to the corporation, since, at least as
a first approximation, all it does is redistribute wealth from
him to the majority shareholder; it does not reduce the value
No. 02-4330 7
of the corporation. To force the minority shareholder’s suit
into the derivative mold would have the paradoxical result
that the majority shareholder would be the main beneficiary
of any judgment or settlement that resulted from the suit; he
would be on both sides of the litigation. But that is not this
case.
The question whether a suit is derivative by nature or may
be brought by a shareholder in his own right is governed by
the law of the state of incorporation, Frank v. Hadesman &
Frank, Inc., 83 F.3d 158, 159 (7th Cir. 1996); Bagdon v.
Bridgestone/Firestone, Inc., 916 F.2d 379, 382 (7th Cir. 1990);
7547 Corp. v. Parker & Parsley Development Partners, 38 F.3d
211, 220-21 (5th Cir. 1994), in this case Delaware. The
plaintiffs complain about Cadant’s having been reincorpo-
rated in Delaware, but that is immaterial so far as the law
applicable to the choice between derivative and direct suits
is concerned because Maryland uses the same basic ap-
proach (albeit formulated somewhat differently) to deriva-
tive status as Delaware does. Compare Waller v. Waller, 49
A.2d 449, 452-53 (Md. 1946), and Danielewicz v. Arnold, 769
A.2d 274, 284 (Md. App. 2001), with Kramer v. Western
Pacific Industries, Inc., 546 A.2d 348, 351 (Del. 1988), and
Moran v. Household International, Inc., 490 A.2d 1059, 1070
(Del. Ch. 1985), aff'd, 500 A.2d 1346 (Del. 1985). It is true
that Strougo v. Bassini, 282 F.3d 162, 171-72 n. 6 (2d Cir.
2002), conjectured that Delaware may require that the harm
to the plaintiff shareholders be different from the harm to
the rest of the common shareholders (the “undifferentiated
harm” test) for a direct suit to lie, though no Delaware case
says this. But probably all that is meant by the reference to
“undifferentiated harm” is that if all the common sharehold-
ers are harmed equally, the case is unlikely to fit the
majority-oppressing-the-minority pattern that allows a
direct suit to be brought.
8 No. 02-4330
In any event the plaintiffs cannot complain about the ap-
plication of Delaware law in consequence of the reincor-
poration of Cadant in Delaware because the very case they
rely on to show they’re entitled to bring a direct suit is a
Delaware case. In re Tri-Star Pictures, Inc., Litigation, 634
A.2d 319 (Del. 1993), imposed the fiduciary obligation that
a majority shareholder owes minority shareholders on a
nonmajority shareholder, Coca-Cola. Tri-Star will not do the
trick for the plaintiffs in our case, however. The extension of
fiduciary duty by that decision was a modest one, as our
plaintiffs’ own summary of the case makes clear: “The
control and domination by Coca-Cola was established by
the shareholder agreements which gave it voting control
over 56.6% of the outstanding stock and eight out of ten
board seats.” If shareholders owning in the aggregate a
majority of the corporation’s common stock get together and
agree to use their control of the corporation to plunder the
minority shareholders, the latter have suffered an individual
wrong and can sue the controlling shareholders directly. See
also Rabkin v. Philip A. Hunt Chemical Corp., 547 A.2d 963,
969 (Del. Ch. 1986); compare Behrens v. Aerial Communica-
tions Inc., 2001 WL 599870, at *3, 5 (Del. Ch.). In the case of
oppression by a majority created by contract, just as in the
case of oppression by a majority based on single ownership,
there may have been no injury to the corporation, and
therefore no occasion for the filing of a derivative suit. The
more valuable a corporation is, the more valuable the
control of it is. The controlling shareholders want a larger
slice of the pie, not a smaller pie, though if the larger slice of
a smaller pie is larger than the smaller slice of a larger pie,
they will go for the former.
There are two critical differences between this case and
Tri-Star. The first is that there was no agreement between
Venrock and J.P. Morgan (nor do they have overlapping
ownership or management) to control Cadant, as there was
No. 02-4330 9
between Coca-Cola and other shareholders, together con-
stituting a majority, to control Tri-Star. The plaintiffs’ con-
cocted term “Venrock Affiliates” and the expression “in
virtual tandem” are obfuscations intended to conceal the
absence of an agreement or conspiracy, nowhere alleged in
the complaint and expressly disclaimed in the plaintiffs’
reply brief. Venrock and J.P. Morgan, as large investors in
Cadant, had parallel interests—that much is certainly true.
But if having parallel interests is enough to make investors
a control group owing a fiduciary obligation to the other
investors, judicial interference in the affairs of corporations
will be enormously magnified. There is no legal or economic
basis for extending fiduciary obligation so far.
Second, the defendants were not common shareholders at
all, let alone a controlling bloc of them. The statement in the
plaintiffs’ opening brief that “Venrock Affiliates was
a controlling shareholder who owed a fiduciary duty to
the other stockholders of Cadant” is nonsense. Remember,
there is no such entity, whether loose-knit or tight-knit, as
“Venrock Affiliates.” The defendants never exercised their
warrants to purchase common stock.
If an entity that is not a common shareholder steals a cor-
poration’s assets, the corporation is the victim of the wrong
and owns the cause of action against the thief. We cannot
see what difference it makes whether the thief is a complete
outsider or, as in this case, a preferred shareholder, who is
a kind of lender, or at least quasi-lender, because on the one
hand he has a specified return but on the other hand the
return can be changed by the corporation and he has more
authority over management than a conventional lender. See,
e.g., “Preferred Stock,” Management and Technology Dictio-
nary, http://www.legamedia.net/lx/result/match/
3216767669113a143fc04522d/index.php (“most people see
preferred stock as debt with a tax advantage.”); Lee A.
10 No. 02-4330
Sheppard, “Should Junk Bond Interest Deductions Be Dis-
allowed?” 34 Tax Notes 1142, 1146 (1987); Bruce N. Davis &
Steven R. Lainoff, “U.S. Taxation of Foreign Joint Ventures,”
46 Tax L. Rev. 165, 219 (1991). Who steals assets of a corpora-
tion injures the corporation, and the right of redress there-
fore belongs to the corporation, and so the plaintiffs could
not maintain this suit as a direct suit against Venrock and
J.P. Morgan even if the defendants had conspired with each
other to control Cadant and had succeeded in controlling it.
We would have a different case had the defendants exer-
cised their warrants and become common shareholders.
That would have diluted the voting power of the plaintiffs
vis-à-vis the defendants. Lipton v. News Int’l, Plc., 514 A.2d
1075, 1078-79 (Del. 1986); Reifsnyder v. Pittsburgh Outdoor
Advertising Co., 173 A.2d 319, 322-23 (Pa. 1961); Avacus
Partners, L.P. v. Brian, 1990 WL 161909, at *6-7 (Del. Ch.). It
would have redistributed power, and hence potentially
wealth, between two groups of common shareholders, in-
juring one group without, once again, necessarily injuring
the corporation. As Lipton and Reifsnyder put it, there would
be an injury to the plaintiffs’ contractual rights. There was
no dilution in this case because the defendants never
became common shareholders.
But although this suit thus cannot be maintained as a
direct suit against Venrock and J.P. Morgan, remember that
the suit is against individuals as well. Cadant’s directors are
accused of having issued a misleading proxy statement as
a result of which the common shareholders, including the
plaintiffs, were bamboozled into agreeing to the rein-
corporation of Cadant in Delaware, which gives share-
holders less protection than Maryland does. Directors, like
majority shareholders (and thus unlike Venrock or J.P.
Morgan), have of course a fiduciary obligation to the share-
holders. The charge that Cadant’s directors issued a mis-
No. 02-4330 11
leading proxy statement in violation of their fiduciary
obligation is a legitimate direct claim, In re Tri-Star Pictures,
Inc., Litigation, supra, 634 A.2d at 330-32, since the effect of
the reincorporation was to reduce the shareholders’ power
over the corporation’s affairs rather than to reduce the value
of the corporation. It shows by the way that a direct suit is
not necessarily precluded by the common shareholders’
having suffered an “undifferentiated harm.” They can suffer
such a harm without the corporation’s being injured. A
corporation might be worth as much after the directors
decided that shareholders would no longer be entitled to
vote on any matter as it had been worth before.
Only there was no fraud, at least no actionable fraud, re-
garding the reincorporation. The proxy statement contained
more than 20 pages on the differences between Maryland
and Delaware law, and specifically mentioned that certain
transactions that require a supermajority in Maryland can
be approved in Delaware by a simple majority. There is no
actionable fraud without reasonable reliance, and reliance
cannot be reasonable when it presupposes a failure to read
clear language. Carr v. CIGNA Securities, Inc., 95 F.3d 544,
547 (7th Cir. 1996); In re Mayer, 51 F.3d 670, 676 (7th Cir.
1995); Jackvony v. RIHT Financial Corp., 873 F.2d 411, 416-17
(1st Cir. 1989); Zobrist v. Coal-X, Inc., 708 F.2d 1511, 1517-
19 (10th Cir. 1983).
The plaintiffs complain about other omissions from the
proxy statement as well, concerning Cadant’s dismal finan-
cial condition, conflicts of interest of directors, and “biogra-
phies of directors, director compensation, if any, amount of
stock held by officers, directors, and 5% owners, executive
compensation, related party transactions, compensation
paid to officers and information regarding employment
contracts.” Such omissions might or might not be material.
Current financial information isn’t always material to the
12 No. 02-4330
election of directors, who after all are not responsible for the
day-to-day running of the corporation (it is even less likely
to be material to a decision to reincorporate in another
state); and so there is no per se rule that financial informa-
tion must be included in a proxy solicitation— its material-
ity must be demonstrated case by case. See Loudon v. Archer-
Daniels-Midland Co., 700 A.2d 135, 143 (Del. 1997); compare
Arnold v. Society for Savings Bancorp, Inc., 650 A.2d 1270 (Del.
1994). Failing to mention a director’s conflict of interest can
make a proxy statement false and misleading, even when
the directors are running unopposed, Millenco L.P. v. meVC
Draper Fisher Jurvetson Fund I, Inc., 824 A.2d 11 (Del. Ch.
2002), although the potential conflicts alleged here—Lyon’s
soon-to-be-terminated employment with J.P. Morgan,
Copeland’s employment with Venrock, and the fact that
several directors owned preferred shares—seem pretty
tepid.
As for the “biographies,” contracts, and other records,
we are not told what damaging information these might
have revealed that should have been disclosed in the proxy
statement. We cannot tell, therefore, whether there might be
a viable claim buried somewhere in the quoted passage.
What is more, the quotation comes from the plaintiffs’
opening brief rather than from their complaint, where no
such charge is made. They explain that in their brief they are
merely embroidering the terse charge in the complaint that
“the Defendant Venrock Affiliates and the First Venrock
Bridge Affiliates [another fictitious name] breached their
fiduciary duties to Cadant by . . . submitting a proxy
statement to the common stockholders of Cadant containing
material omissions and misstatements, for the purpose of
removing control of Cadant from the common stockhold-
ers.” They cite cases that permit plaintiffs to defend against
dismissal by alleging in their brief facts consistent with but
not contained in the complaint. Albiero v. City of Kankakee,
No. 02-4330 13
122 F.3d 417, 419 (7th Cir. 1997); Orthmann v. Apple River
Campground, Inc., 757 F.2d 909, 915 (7th Cir. 1985); cf. Pegram
v. Herdrich, 530 U.S. 211, 230 n. 10 (2000); Southern Cross
Overseas Agencies, Inc. v. Wah Kwong Shipping Group Ltd., 181
F.3d 410, 428 n. 8 (3d Cir. 1999). But such supplementation
cannot save the charge if the charge is one of fraud, because
a charge of fraud must be pleaded with particularity. Fed. R.
Civ. P. 9(b). It is not even enough for the plaintiff to submit
affidavits that particularize the complaint’s charge of fraud.
Miller v. Gain Financial, Inc., 995 F.2d 706, 709 (7th Cir. 1993).
A fortiori he cannot use his appeal brief to plead for the first
time with the requisite particularity. The complaint must
allege “the identity of the person making the misrepresenta-
tion, the time, place, and content of the misrepresentation,
and the method by which the misrepresentation was
communicated to the plaintiff.” Sears v. Likens, 912 F.2d 889,
893 (7th Cir. 1990); see also Bankers Trust Co. v. Old Republic
Ins. Co., 959 F.2d 677, 682 (7th Cir. 1992); Midwest Commerce
Banking Co. v. Elkhart City Centre, 4 F.3d 521, 524 (7th Cir.
1993); DiLeo v. Ernst & Young, 901 F.2d 624, 627 (7th Cir.
1990). “[S]ubmitting a proxy statement to the common
stockholders of Cadant containing material omissions and
misstatements, for the purpose of removing control of
Cadant from the common stockholders” does not satisfy this
standard. Elsewhere in the complaint the plaintiffs do
specify the time and place of the alleged omissions and
misstatements, but do not say what they were.
But in charging that the proxy statement contained ma-
terial omissions and misstatements, are the plaintiffs charg-
ing fraud, and fraud alone? For if not, Rule 9(b) falls out of
the picture. Plaintiffs don’t have to charge fraud in a case
such as this in order to state a claim. Negligent omission of
material information from a proxy statement violates both
federal securities law, see Section 14(a) of the Securities
Exchange Act of 1934, 15 U.S.C. § 78n(a); 17 C.F.R.
14 No. 02-4330
§ 240.14a-9; Dasho v. Susquehanna Corp., 461 F.2d 11, 29-30
n. 45 (7th Cir. 1972); Wilson v. Great American Industries, Inc.,
855 F.2d 987, 995 (2d Cir. 1988); Shidler v. All American Life
& Financial Corp., 775 F.2d 917, 926-27 (8th Cir. 1985), and
Delaware law, which governs claims for breach of the fidu-
ciary duty of disclosure by directors of Delaware corpora-
tions. Oliver v. Boston University, 2000 WL 1091480, at *8
(Del. Ch. 2000). Rule 9(b) is strictly construed; it applies to
fraud and mistake and nothing else. Leatherman v. Tarrant
County Narcotics Intelligence & Coordination Unit, 507 U.S.
163, 168 (1993); Pizzo v. Bekin Van Lines Co., 258 F.3d 629,
634 (7th Cir. 2001); Hammes v. AAMCO Transmissions, Inc.,
33 F.3d 774, 778 (7th Cir. 1994); In re NationsMart Corp.
Securities Litigation, 130 F.3d 309, 315 (8th Cir. 1997). And if
both fraudulent and nonfraudulent conduct violating the
same statute or common law doctrine is alleged, only the
first allegation can be dismissed under Rule 9(b), Lone Star
Ladies Investment Club v. Schlotzsky’s Inc., 238 F.3d 363, 368-
69 (5th Cir. 2001); In re NationsMart Corp. Securities Litigation,
supra, 130 F.3d at 315, though if, while the statute or com-
mon law doctrine doesn’t require proof of fraud, only a
fraudulent violation is charged, failure to comply with Rule
9(b) requires dismissal of the entire charge. Vess v. Ciba-
Geigy Corp. USA, 317 F.3d 1097, 1103-05 (9th Cir. 2003);
Shapiro v. UJB Financial Corp., 964 F.2d 272, 288 (3d Cir.
1992).
The complaint does not charge that the directors’ failure
to disclose their “biographies” and other information in
records and contracts was fraudulent. Although the com-
plaint does state that the defendants’ lawyers “knew or
should have known that the Proxy Statement was fraudu-
lent and misleading,” this does not necessarily mean that all
the omissions complained of were fraudulent. In their briefs
in this court, however, the plaintiffs make clear that they
indeed are claiming that all the omissions were fraudulent.
No. 02-4330 15
For example, the omissions are discussed in a section of the
plaintiffs’ opening brief captioned: “The proxy [statement]
was fraudulent for a host of reasons not addressed by the
district court.” It is apparent that if the case were to be
remanded, the plaintiffs would try to prove that the omis-
sions were fraudulent, and that they have no alternative
theory of liability. If, then, the briefs are treated as amend-
ing the complaint to make clear that the omissions are being
complained of solely because they were fraudulent, Rule
9(b) has been violated.
It is true that a plaintiff cannot amend his complaint in his
appeal brief. Harrell v. United States, 13 F.3d 232, 236 (7th
Cir. 1993); Thomason v. Nachtrieb, 888 F.2d 1202, 1205 (7th
Cir. 1989). But just as he might make a concession in his
brief that showed that his case has no merit, though that
might not have been apparent from the complaint, Harrell v.
United States, supra, 13 F.3d at 235-36, so he can be estopped
by statements in his appeal brief to deny the interpretation
that the brief places on the complaint, if the invocation of
estoppel is required for the protection of his opponent. As
it is here. A principal purpose of requiring that fraud be
pleaded with particularity is, by establishing this rather
slight obstacle to loose charges of fraud, to protect individu-
als and businesses from privileged libel (privileged because
it is contained in a pleading). Ackerman v. Northwestern
Mutual Life Ins. Co., 172 F.3d 467, 469-70 (7th Cir. 1999);
Bankers Trust Co. v. Old Republic Ins. Co., supra, 959 F.2d at
682-83; Vess v. Ciba-Geigy Corp. USA, supra, 317 F.3d at 1104;
In re Burlington Coat Factory Securities Litigation, 114 F.3d
1410, 1418 (3d Cir. 1997); Ross v. Bolton, 904 F.2d 819,
823 (2d Cir. 1990). That purpose is thwarted by the filing of
a stealth complaint in which allegations of fraud are
avoided only to be added later by way of brief or other
filing. Such an end run should not be permitted. This
conclusion is supported by Nolan Bros., Inc. v. United States
16 No. 02-4330
for Use of Fox Bros. Construction Co., 266 F.2d 143, 145-
46 (10th Cir. 1959), which holds that the word “fraud” need
not appear in the complaint in order to trigger Rule 9(b). Cf.
Minger v. Green, 239 F.3d 793, 800-01 (6th Cir. 2001).
Rule 9(b) does not permit us to dismiss the fraud alleg-
ations that are based on the failure of the proxy statement to
disclose Cadant’s financial information and directors’ con-
flicts of interest. But those charges fall, on the merits, with
the charge of fraudulent nondisclosure of the reincorpor-
ation (which we said was not fraudulent). The key allega-
tion in the complaint against the director defendants is that
they “submitted a proxy statement to the common stock-
holders of Cadant containing material omissions and
misstatements, for the purpose of removing control of Cadant
from the common stockholders” (emphasis added). The only
“removal of control” charged is the reincorporation of
Cadant in Delaware, which reduced the shareholders’ con-
trol over certain transactions. As to that, the shareholders
could not be deceived, because the proxy statement de-
scribed the consequences of reincorporation at great length.
All the other charges in the complaint involve injury to the
corporation. The common shareholders were injured by that
injury, but that makes their claim against the defendants,
the injurers, indirect and so bars their prosecuting the claim
outside of the bankruptcy proceeding.
AFFIRMED.
A true Copy:
Teste:
_____________________________
Clerk of the United States Court of
No. 02-4330 17
Appeals for the Seventh Circuit
USCA-02-C-0072—10-29-03