Business Law & Bankruptcy
Assignment #3
Joan sits on the board of ManBank, a large publicly held bank located in New York City. Her friend Bob asks her for a loan of $300 million to start a new airline. Joan researches Bob’s background and discovers that Bob worked as an assistant regional manager for a Midwest airline for 12 years, and during Bob’s tenure there, his region increased sales by 28%. Based on this information and on her friendship with Bob, Joan recommends Bob for the loan, and the board accepts her recommendation. Bob’s airline falls into bankruptcy, Bob defaults on the loan, and the bank is only able to recover $150 million. The shareholders bring a derivative lawsuit against Joan for breach of her fiduciary duty of care. They claim that her research into Bob was deficient, and based on Bob’s background and the state of the airline industry Joan should have known that the venture was not likely to succeed.
Is Joan’s conduct protected by the business judgment rule, and is the derivative action against Joan likely to succeed?
InBayer v. Bayer, 49 N.Y.S.2d 2 (N.Y. 1944), Doctors Camille and Henri Dreyfus conceived chemical processes and inventions, and organized a successful and profitable corporation, Celanese Corporation of America, to market these original discoveries. Doctor Camille Dreyfus served on the board of directors as its president and Doctor Henri Dreyfus as it vice president. Stockholders brought a derivative law suit charging Doctors Camille and Henri Dreyfus with breach of fiduciary duty. They are charged with negligence, waste, and improvidence for embarking upon a radio advertising campaign costing about $1,000,000 a year when the company currently had more orders than it could handle. They are charged with negligence in selecting the type of program that they did, and for renewing the contract for a second year. Further, and more seriously, they are accused of being motivated by a non-corporate purpose in undertaking this radio advertising campaign. It is claimed that the radio advertising was for the benefit of Miss Jean Tennyson, one of the singers on the program, who in private life is really Mrs. Dreyfus, the wife of Doctor Camille Dreyfus. The Doctors Dreyfus are being accused of undertaking the radio campaign to “foster and subsidize her career” and to “furnish a vehicle” for her talents.
The court sought to clarify the obligations of directors of business corporations before he applied the specifics of this case to them. “Directors of a business corporation are not trustees and are not held to strict accountability as such. Directors are agents; they are fiduciaries. The fiduciary has two paramount obligations: responsibility and loyalty… The responsibility, that is, the care and the diligence, required of an agent or of a fiduciary, is proportioned to the occasion. It is a concept that has, and necessarily so, a wide penumbra of meaning: a concept, however, which becomes sharpened in its practical application to the given facts of a situation.” So the court will have to apply the law as it relates to this specific situation to decide if the Doctors acted responsibly.
The court then clarified the concept of loyalty by quoting Supreme Court Justice Stone who declared that the fiduciary principle of undivided loyalty was “the precept as old as Holy Writ, that ‘a man cannot serve two masters.’ … No thinking man can believe that an economy built upon business foundation can long endure without loyalty to that principle… The separation of ownership from management, the development of the corporate structure so as to vest in small groups control of resources of great numbers of small and uninformed investors, make imperative a fresh and active devotion to that principle if the modern world of business is to perform its proper function.”Stone, The Public Influence of the Bar, 48 Harvard Law Review 1, 8.
The court then went on to explain that “the director of a business corporation is given a wide latitude of action. The law does not seek to deprive him of initiative and daring vision.” A director, who in good faith, and in the interest of the corporation, embarks upon a project, cannot be penalized if failure results instead of success. The law does not hold directors liable for honest mistakes of judgment. The court went on to explain that “To encourage freedom of action on the part of directors … to discourage interference with the exercise of their free and independent judgment, there has grown up what is known as the ‘business judgment rule’… it is only in a most unusual and extraordinary case that directors are held liable for negligence in the absence of fraud, or improper motive, or personal interest…The business judgment rule … yields to undivided loyalty.”
The court noted that the “character of the advertising, the amount to be expended therefor, and the manner in which it should be used are all matters of business judgment and rest peculiarly within the discretion of the board of directors… it is not… the function of a court of equity to review these matters or even to consider them. Had the wife of the president of the company not been involved, the advertising cause of action could have been disposed of summarily. Her connection with the program, however, makes it necessary to go into the facts in some detail.” The courts concern was that this is not a close family held corporation. It has 1,376,500 shares of common stock outstanding, 135,000 shares held by Doctors Dreyfus and their families, and 10,000 held by the other directors. Miss Jean Tennyson, a close relative to the chief officer of the corporation, benefited from the radio campaign. The court found that it is not improper to appoint relatives to positions, but such appointments have to be “subjected to the most rigorous scrutiny to determine whether the action of the directors was intended or calculated to sub-serve some outside purpose…” The court must decide if this was a case of divided loyalty, or if it was a decision made in good faith.
The court found that the musical quality of the Celanese Hour has not been challenged, nor is anyone complaining about Miss Tennyson’s competence. Her compensation was in conformity with that paid for comparable work, she received less than any other artist on the program although she appeared with greater regularity than the other performers, she received no undue prominence, no special build up, and the popularity of the program increased over time. Although the doctors have perhaps unwisely placed themselves in a position where their motives were questioned, the court found that they may employ the services of an acquaintance, and have not been guilty of breach of fiduciary duty. They acted in the free exercise of their honest business judgment and their conduct did not constitute negligence, waste, or improvidence. The complaint was dismissed.
InFederal Deposit Insurance Corporation v. Lawrence Bober, 95 Civ. 9529 (S.D.N.Y. 2002) the FDIC, as receiver for First New York Bank For Business, brought an action against former directors of the bank for, among other things, breach of fiduciary duty. At issue were nine loans and lines of credit that were extended to a few of the directors. Between 1987 and 1992, the Board of Directors of the bank approved of and issued preferential loans to various bank insiders. Outstanding loans to bank insiders totaled approximately $98.5 million or 161 % of the bank capital. The financial condition of the bank deteriorated and the bank was finally closed by the Superintendent of Banks of the State of New York.
The FDIC alleged that the directors violated their fiduciary duties in approving these loans. They were poorly underwritten, involved more than the normal risk of payment, and violated the bank’s internal lending policy. The defendants based their response on the business judgment rule, which they contended, shields them from liability if the underlying business decisions were made in good faith.
The issue presented on this motion was whether bank directors are entitled to avail themselves of the New York business judgment rule as a defense to claims related to the extension of credit.
New York Business Corporation Law§717(a) states: “A director shall perform his duties as a director, including his duties as a member of any committee of the board upon which he may serve, in good faith and with that degree of care which an ordinary prudent person in a like position would use under similar circumstances.”
The court found that while this rule is applicable to decisions of corporate directors, it has not generally been found to apply to bank directors. Bank directors were traditionally held to a higher standard of diligence and were subject to the New York Banking Law§ 7015(1) which states: “ Directors and officers shall discharge the duties of their respective positions in good faith and with that degree of diligence, care and skill which ordinarily prudent men would exercise under similar circumstances in like positions.”
Defendants argued that the business judgment rule was applied to various other bank cases, but the court pointed out that these were cases about mergers, which is a common corporate function. The business judgment rule is not generally used in cases that involve loans.
Defendants argued that given the similarities between both laws, the N.Y. Banking Law § 7015(1) should be read as extending the business judgment rule to bank directors. The court disagreed, noting that the legislatures added extra language requiring “diligence” and “skill” to § 7015(1). “The legislature is assumed to know what the law is, and if the legislature intended to completely harmonize the standards to which bank directors and corporate directors are held, it presumably would have used the exact same language… Accordingly, the business judgment rule is not available as an affirmative defense under these particular circumstances.”
InLeonard Minzer v. Gerard C. Keegan, Lexis 16445 (U.S. Dist. 1997) a stockholders’ class action lawsuit was brought against The Greater New York Savings Bank (GNYSB) seeking to enjoin a proposed merger between GNYSB and Astoria Financial Corporation (AFC). Among other claims, they assert state law breach of fiduciary duty claims against the defendants. Before the court is plaintiffs’ motion for a preliminary injunction.
GNYSB directors made a merger deal with AFC. North Fork Bancorporation wanted to meet with GNYSB directors to make a merger deal with them. North Fork offered a pooling of interest, which would translate into a more profitable offer for shareholders than the purchase terms of the merger in AFC’s arrangement. The board of directors of GNYSB made the deal with AFC nonetheless. In this arrangement, members of the board of GNYSB were given offers to sit on an advisory board, and receive a $24,000 per year retainer fee. In addition, they received options to purchase 4,000 shares of AFC common stock and full retirement benefits. AFC and GNYSB distributed a joint proxy statement and the merger was approved by the stockholders.
Three days after the merger was announced, plaintiffs commenced on an action in the New York state court alleging that GNYSB and its directors breached their fiduciary obligations to their shareholders. Plaintiffs claimed that the proxy statements were misleading, that shares in North Fork would have been more profitable to GNYSB’s shareholders, that North Fork should be given the due diligence that it seeks, and GNYSB should hold a new meeting to revote the merger issue.
Defendants then explained to the court why they made each decision that they did, that in their judgment this was a better offer, and clarified the fact that a merger with North Fork would have resulted in similar benefits for the directors of GNYSB.
Plaintiffs cited a Delaware law to establish their case; that directors of a corporation have an obligation to seek transactions offering the best value to shareholders. The court explained that New York law has different standards than Delaware when deciding whether the defendants’ conduct complied with their fiduciary obligations, and New York Banking Law § 7015(1) is what applies in this case.
To clarify the standards required in New York Banking Law § 7015(1), the court referred toAuerbach v. Bennett, 47 N.Y.2d 619 (N.Y. 1979), a case wherea specially appointed committee of disinterested directors--acting on behalf of defendant, a board of directors of a corporation--made a decision to terminate a shareholders' derivative action.The court noted in this case that “courts are ill equipped … to evaluate what are and must be essential business judgments.”
Similarly the court referred to Alpert v. 28 Williams St. Corp, 457 N.Y.S.2d 4 (App. 1982)a case in which defendants, directors and majority shareholders, appealed the decision of the Supreme Court, New York County, which entered judgment for plaintiffs, minority shareholders, in their action to hold the directors and majority shareholders liable for approving a merger agreement,where the court in reference to New York Banking Law § 7015(1), ruled for defendants stating that “it will not overturn an informed decision of directors absent some showing of fraud, illegality or self-dealing.”