A judge should not have ruled against stockholders challenging the fairness of a corporate merger without first affording them an opportunity to conduct additional discovery, the 1st U.S. Circuit Court of Appeals has found.

The plaintiff shareholders argued that summary judgment was premature because they had not been provided with the discovery they had sought.

The 1st Circuit agreed and vacated the summary judgment award.

“In a matter like this, when ‘plaintiffs’ case turns so largely on their ability to secure evidence within the possession of defendants, courts should not render summary judgment because of gaps in a plaintiff’s proof without first determining that plaintiff has had a fair chance to obtain necessary and available evidence from the other party,’” Judge John J. McConnell Jr. wrote for the unanimous three-judge panel. “To rule otherwise would encourage defendants ‘to “stonewall” during discovery — withholding or covering up key information that is otherwise available to them through the exercise of reasonable diligence.’”

The 14-page decision is In Re: PHC, Inc. Shareholder Litigation.

Chet B. Waldman of New York argued the appeal on behalf of the plaintiff shareholders. He was opposed by James H. Hulme of the District of Columbia.

Discovery stymied

Plaintiffs MAZ Partners and Peter Blakeslee were holders of Class A common stock of PHC, Inc. Alleging that an announced merger between PHC and Acadia Healthcare Co. was the result of an unfair process that provided them with too little compensation, the plaintiffs sued PHC, Acadia and Acadia Merger Sub, LLC (an entity created to facilitate the merger), as well as PHC’s chairman, several directors and a board member.

The plaintiffs claimed that the defendants breached their fiduciary duty to Class A stockholders because the announced merger between PHC and Acadia gave them only one quarter of one share of Acadia common stock for each share of PHC stock they owned. In contrast, in addition to the one quarter of one share of Acadia common stock, a $5 million cash payment was made to the holders of PHC Class B common stock. The vast majority (93.2 percent) of that stock was owned by defendant Bruce A. Shear, PHC’s president, chief executive officer and chairman. Shear negotiated the merger’s terms.

When the defendants moved for judgment on the pleadings, U.S. District Court Judge George A. O’Toole Jr. denied the motion for procedural reasons and then stated that “a motion for summary judgment may be appropriate” but he did not “know whether we’re at the stage yet where there would be agreement on both sides that the factual record is so clear that that’s appropriate.”

The judge went on to “anticipate the possibility” of a motion under Rule 56(d) of the Federal Rules of Civil Procedure and said, “I think we should maybe just permit some discovery before the [summary judgment] motion is filed and head that off.”

A month later, the defendants moved for summary judgment. The plaintiffs submitted an affidavit pursuant to Rule 56(d) of the Federal Rules of Civil Procedure. The 14-page Rule 56 affidavit chronicled the plaintiffs’ attempts to obtain discovery and the defendants’ failure to provide it. It delineated the categories of information about which the identified witnesses were likely to have information and specified the essential information, in defendants’ hands, that would support the plaintiffs’ opposition to the motion for summary judgment.

O’Toole granted summary judgment without addressing the lack of discovery or the Rule 56 affidavit.

‘Perseverant efforts’

The 1st Circuit noted that that discovery had barely begun before summary judgment was entered in this case. “The Rule 56 Affidavit establishes plaintiffs’ persistence in their pursuit of discovery at an early stage of the litigation,” McConnell observed.

“On multiple occasions, the parties reached agreement on discovery schedules but defendants did not comply; instead, they sought to stay discovery and filed numerous motions,” the 1st Circuit found. “Much of the information sought was within defendants’ control, ‘a factor which weighs heavily in favor of relief under Rule 56(f).’”

The 1st Circuit went on to find that the plaintiffs timely sought discovery from the defendants relevant to the issues presented in the motion for summary judgment.

“In the Rule 56 Affidavit, the plaintiffs articulate how the discovery sought pertains to material factual disputes, such as the Individual Defendants’ fiduciary duties, potential conflicts of interest of financial advisors, the relationships among the Individual Defendants, and the existence of other merger opportunities,” McConnell stated.

“Despite plaintiffs’ perseverant efforts, minimal discovery in the conventional sense took place,” he said. “Under these circumstances, the district court’s disregard of plaintiffs’ detailed, plausible, and comprehensive Rule 56 Affidavit was plainly wrong and an abuse of discretion.”