Opinion ID: 410938
Heading Depth: 2
Heading Rank: 3

Heading: Termination of Derivative Suits by Special Litigation Committees

Text: 29 In the normal course of events a decision whether to bring a lawsuit is a corporate economic decision subject to the business judgment rule. United Copper Securities Co. v. Amalgamated Copper Co., 244 U.S. 261, 37 S.Ct. 509, 61 L.Ed. 1119 (1917). Thus, shareholders upset at a corporate failure to bring actions for, say, non-payment of a debt for goods sold and delivered, may not initiate a derivative suit without first making a demand upon the directors to bring the action. Where the directors refuse, and the derivative action challenges that refusal, courts apply the business judgment rule to the action of the directors. In a demand-required case, therefore, the directors' decision will be conclusive unless bad faith is proven. 30 Different rules apply, however, in the cases which primarily concern us here. When there is a conflict of interest in the directors' decision not to sue because the directors themselves have profited from the transaction underlying the litigation or are named defendants, no demand need be made and shareholders can proceed directly with a derivative suit. Note, Demand on Directors and Shareholders as a Prerequisite to a Derivative Suit, 73 Harv.L.Rev. 746, 753-56 (1960). It is in demand-not-required cases that the special litigation committee plays its role. 31 Appellees argue that, because special litigation committees are composed of independent directors--usually newly-elected directors who are not defendants--courts should treat their recommendations as the equivalent of a board refusal to bring an action in demand-required cases. If that proposition were accepted, the business judgment rule would apply in full force to the recommendation, and judicial scrutiny would be limited to the good faith, independence and thoroughness of the committee, as it is in the case of everyday business decisions. Appellant argues, on the other hand, that such committees are transparent devices enabling implicated directors to avoid liability and that derivative actions in demand-not-required cases are immune from termination whatever the recommendation of special litigation committees. We disagree with both parties. 32 We believe Connecticut would not adopt appellees' contention that the business judgment rule should play a major role where a special litigation committee recommends termination of an action in a demand-not-required case, such as the one before us. 7 As a practical matter, new board members are selected by incumbents. The reality is, therefore, that special litigation committees created to evaluate the merits of certain litigation are appointed by the defendants to that litigation. It is not cynical to expect that such committees will tend to view derivative actions against the other directors with skepticism. Indeed, if the involved directors expected any result other than a recommendation of termination at least as to them, they would probably never establish the committee. 8 The conflict of interest which renders the business judgment rule inapplicable in the case of directors who are defendants is hardly eliminated by the creation of a special litigation committee. 33 It is here that we part company with Judge Cardamone. While he recognizes that the business judgment rule has never applied to corporate decisions tainted by a conflict of interest, he argues that the conflict in the defendants' creation of a committee to determine whether this action should be terminated is wholly cured by a judicial finding that the committee acted independently and in good faith. This view is a major departure from the traditional scrutiny courts have given to the underlying fairness of corporate decisions which benefit directors. Lattin, Corporations at 293; see also Ferris v. Polycast Technology Corp., 180 Conn. 199, 208-09, 429 A.2d 850, 854 (1980) and cases cited therein. To be sure, Judge Cardamone is correct in anticipating difficulties in judicial review of the recommendations of special litigation committees. These difficulties are not new, however, but have confronted every court which has scrutinized the fairness of corporate transactions involving a conflict of interest. 34 Moreover, the difficulties courts face in evaluation of business decisions are considerably less in the case of recommendations of special litigation committees. The relevant decision--whether to continue litigation--is at hand and the danger of deceptive hindsight simply does not exist. Moreover, it can hardly be argued that terminating a lawsuit is an area in which courts have no special aptitude. Citytrust's Special Litigation Committee concluded that there was no reasonable possibility that 23 outside defendants would be held liable. A court is not ill-equipped to review the merits of that conclusion. Even when the Committee recommendation arises from the fear of further damage to the corporation, for example, the distraction of key personnel, the cost of complying with discovery, and the possible indemnification of defendants out of the corporate treasury, courts are not on unfamiliar terrain. The rule we predict Connecticut would establish emphasizes matters such as probable liability and extent of recovery. For these reasons we hold that the wide discretion afforded directors under the business judgment rule does not apply when a special litigation committee recommends dismissal of a suit. 35 We think Connecticut would reject appellees' argument for a second reason. Limiting judicial scrutiny in cases such as the one before us to the good faith, thoroughness and independence of the special litigation committee would effectively eliminate the fiduciary obligation of directors and officers. As adumbrated further below, the present action involves classic allegations and substantial evidence of mismanagement and perhaps deliberate wrongdoing resulting in a loss exceeding 10% of the shareholders' capital and equity. The traditional fiduciary obligations of directors and officers under Connecticut law can hardly be said to exist if the sole enforcement method can be eliminated on a recommendation of the defendants' appointees. Other well-understood principles of corporate law would also be altered. For example, the requirement of a demand upon directors before initiating a derivative suit does not apply to a case such as the present one, where the corporate directors and officers are defendants. One reason--the other being futility--underlying the rule is that directors and officers cannot render a fair judgment on allegations of their own misconduct. Appellees would have us substantially modify this by allowing the defendants to appoint a committee to evaluate these allegations and impose their conclusions on the plaintiffs. In derivative actions, the plaintiffs have always controlled the action subject to judicial findings of adequate representation of shareholders and approval of settlements. See Conn.Gen.Stat.Ann. Sec. 52-572j (West 1982). Appellees' view essentially vests power in defendants' appointees to bring about their dismissal. 36 We are aware that Auerbach v. Bennett, 47 N.Y.2d 619, 419 N.Y.S.2d 920, 393 N.E.2d 994 (1979), held that the business judgment rule limits judicial scrutiny of the recommendations of special litigation committees to their good faith, thoroughness and independence. Because we believe that test would work a major transformation of Connecticut corporate law, we predict that Connecticut would not adopt it. While the ongoing debate over the legal obligations of corporate management has spawned literature from Connecticut commentators calling for less judicial scrutiny of corporate transactions, Wolfson, A Critique of Corporate Law, 34 Miami L.Rev. 959 (1980), the special litigation committee, as envisioned in Auerbach, seems a rather blunt instrument to accomplish that end, since it appears to allow dismissals in actions for deliberate looting as well as in nuisance suits. 37 We detect no signals that Connecticut law is moving away from the enforcement of directors' and officers' traditional fiduciary obligations. Connecticut legislation governing indemnification of directors and officers for expenses incurred in litigation supports the view we take here. Conn.Gen.Stat.Ann. Sec. 33-320a(b) (West 1982). Although that provision has no direct application to this case, attitudes toward indemnification are relevant to the issue before us. By its terms, the Connecticut statute is exclusive and cannot be varied by corporate by-laws. It calls for indemnification without court approval only in circumstances in which the defendant directors and officers secure a judgment in their favor. This legislation adopts the middle ground between no indemnification and permissible indemnification without regard to outcome and thus does not bespeak a negative attitude toward enforcement of fiduciary obligations through meritorious derivative litigation. 38 We also disagree with appellant that recommendations of special litigation committees should be ignored by courts in which derivative actions are pending. The incentives underlying derivative litigation are such that actions may well be brought which cannot be dismissed on motion but which also are unlikely to lead to net benefits to the corporation. At least where the effectuation of an overriding federal policy is not at stake, cf. Galef v. Alexander, 615 F.2d 51, 62 (2d Cir.1980) (serious questions whether a special litigation committee can seek dismissal of an action alleging federal proxy violations), a corporation can play a legitimate role in aiding a court to determine whether the maintenance of an action in its name is in fact in its interest. Surviving a motion to dismiss and for summary judgment establishes only that a claim for relief has been stated and that there is a scintilla of evidence to support it. It does not establish that continued prosecution of the action is actually in the corporation's interest. 39 Appellant argues that Connecticut recognizes an absolute right to bring and continue a derivative action. The statute relied upon, however, Conn.Gen.Stat.Ann. Sec. 52-572j, 9 is clearly of a procedural nature directing how and where such actions may be brought in a state court. It has no apparent substantive effect. Appellant also relies upon Conn.Gen.Stat.Ann. Sec. 33-323 (West 1982) 10 which renders transactions between the corporation and directors voidable if unfair to the corporation. She argues that creation of the Committee is thus a voidable corporate act since a majority of those voting were defendants. Since our decision permits dismissal of this action only after an independent judicial finding that it will not benefit the corporation, the statutory fairness requirement is satisfied. 40 The Connecticut statute permitting indemnification with court approval of a director's expenses incurred in defending litigation even when the settlement calls for payment to the corporation, Conn.Gen.Stat.Ann. Sec. 33-320a(b), suggests a recognition by the General Assembly of the fact that some derivative actions may in the end not benefit the corporation. We believe Connecticut law allows a court before which a derivative action is pending to entertain a motion for judgment by a defendant corporation based on a recommendation of a special litigation committee. Before granting such a motion, however, it should apply far more vigorous scrutiny to that recommendation than occurs under the good faith, independence and thoroughness test. While those qualities are necessary even to consideration of the merits of such a motion, they are by no means sufficient to determine whether it should be granted. The reason for entertaining such a motion stems from the nature of the incentives underlying derivative litigation. Because they encourage actions which are not subject to pretrial dismissal but which also may not benefit the corporation, the device of the special litigation committee affords an opportunity for a judicial second look at the underlying litigation. There is no reason, however, to treat the recommendation of such a committee as having presumptive weight or to accord it deference beyond its inherent persuasiveness. The function of judicial scrutiny of a committee's recommendation is to determine independently whether the action is likely to harm the corporation rather than help it. 41 We strongly disagree with the implications of the dissenting opinion that by not according the recommendations of special litigation committees conclusive weight we are somehow embarking on a new course of stricter corporate accountability which will lead to more derivative lawsuits. Such committees are very recent creations. Indeed, Auerbach, the first decision of a state high court to address these issues, was decided only three years ago. Our failure to accord the recommendations of such committees conclusive weight can hardly be regarded as overregulation. And our holding that the recommendations of such committees may be considered by a court and provide the basis for dismissal of a derivative action will hardly lead to an increase in the number of such actions brought. 42 The Auerbach decision gives excessive weight to the recommendations of special litigation committees. In rejecting Auerbach and concluding that Connecticut would adopt a rule limiting the role of such committees, we are not without eminent judicial support. In Zapata Corp. v. Maldonado, 430 A.2d 779 (Del.Supr.1979), the Delaware Supreme Court, which has unique experience in the area, laid down the following rule: Where a derivative suit cannot be brought without prior demand upon the directors followed by refusal, the directors' decision will stand absent a demonstration of self-interest or bad faith; but where such a demand is excused (for reasons of futility, etc.) and a derivative action is properly brought, an independent committee of directors may obtain a dismissal only if the trial court finds both (a) that the committee was independent, acted in good faith and made a reasonable investigation; and (b) that in the court's independent business judgment as to the corporation's best interest, the action should be dismissed. We believe Connecticut would adopt a similar rule. 43 Independent judicial scrutiny of a special litigation committee's recommendation is apt to be difficult and in an effort to ease that task we establish some guidelines. We emphasize that what we say here applies to cases involving allegations of direct economic injury to the corporation diminishing the value of the shareholders' investment as a consequence of fraud, mismanagement or self-dealing. This is not a case involving allegations of ultra vires acts or acts illegal under domestic or foreign laws which do not have as a major purpose protection of the corporate shareholder's investment interest. Compare Gall v. Exxon Corp., 418 F.Supp. 508 (S.D.N.Y.1976). Nor is it a case in which the relief sought may benefit the corporation but in ways not entailing a direct financial return. Mills v. Electric Auto-Lite, supra (action for misleading proxy statement where no monetary recovery by the corporation may result); Bosch v. Meeker Cooperative Light & Power Ass'n, 257 Minn. 362, 101 N.W.2d 423 (1960) (invalidation of directors' elections). The guidelines we establish here are limited to cases involving allegations of acts resulting in direct financial harm to the corporation and a consequent diminishing of the value of shareholders' investment. We express no views on the appropriate calculus to be applied to recommendations of special litigation committees where the derivative action alleges violations of law not designed principally to protect shareholders or, which, if successful, may benefit the corporation in ways other than the recovery of compensatory damages. 44 In cases such as the present one, the burden is on the moving party, as in motions for summary judgment generally, to demonstrate that the action is more likely than not to be against the interests of the corporation. This showing is to be based on the underlying data developed in the course of discovery and of the committee's investigation and the committee's reasoning, not simply its naked conclusions. The weight to be given certain evidence is to be determined by conventional analysis, such as whether testimony is under oath and subject to cross-examination. Finally, the function of the court's review is to determine the balance of probabilities as to likely future benefit to the corporation, not to render a decision on the merits, fashion the appropriate legal principles or resolve issues of credibility. Where the legal rule is unclear and the likely evidence in conflict, the court need only weigh the uncertainties, not resolve them. The court's function is thus not unlike a lawyer's determining what a case is worth for purposes of settlement. 45 Where the court determines that the likely recoverable damages discounted by the probability of a finding of liability are less than the costs to the corporation in continuing the action, it should dismiss the case. The costs which may properly be taken into account are attorney's fees and other out-of-pocket expenses related to the litigation and time spent by corporate personnel preparing for and participating in the trial. The court should also weigh indemnification which is mandatory under corporate by-laws, private contract or Connecticut law, discounted of course by the probability of liability for such sums. We believe indemnification the corporation may later pay as a matter of discretion should not be taken into account since it is an avoidable cost. The existence or non-existence of insurance should not be considered in the calculation of costs, since premiums have previously been paid. The existence of insurance is relevant to the calculation of potential benefits. 46 Where, having completed the above analysis, the court finds a likely net return to the corporation which is not substantial in relation to shareholder equity, it may take into account two other items as costs. First, it may consider the impact of distraction of key personnel by continued litigation. Second, it may take into account potential lost profits which may result from the publicity of a trial. 47 Judicial scrutiny of special litigation committee recommendations should thus be limited to a comparison of the direct costs imposed upon the corporation by the litigation with the potential benefits. We are mindful that other less direct costs may be incurred, such as a negative impact on morale and upon the corporate image. Nevertheless, we believe that such factors, with the two exceptions noted, should not be taken into account. Quite apart from the elusiveness of attempting to predict such effects, they are quite likely to be directly related to the degree of wrongdoing, a spectacular fraud being generally more newsworthy and damaging to morale than a mistake in judgment as to the strength of consumer demand. 48 We do recognize two exceptions, however. First, where the likely net return is not substantial in relation to shareholder equity, the court can consider the degree to which key personnel may be distracted from corporate business by continuance of the litigation. We appreciate that litigation can disrupt the decision-making process and thereby impose unforeseen and undetected costs. These are not measurable and we limit consideration of them to cases where the likely return to the corporation is not great. Where that is the case and many of the key directors and officers will be heavily involved in the litigation, a court may take such potential costs into account. 49 Second, where the corporation deals with the general public and its level of business is dependent upon public identification and acceptance of the corporate product or service, we believe the court ought to take potential business lost as a consequence of a trial into account when the likely net return to the corporation is not substantial in relation to total shareholder equity. In such a case, there is less likelihood of a direct relationship between impact on business and degree of misconduct. Where the likely return to the corporation from the litigation is higher, however, we believe the uncertainty as to the kind of publicity which will attend a trial precludes consideration of that impact. Moreover, when potential lost profits are taken into account, the basis for calculating them must be something more solid than the conclusory opinions of alleged experts, e.g., verifiable examples in similar firms.