June 23, 2012

Memorandum

Re: ManBank’s loan to Bob

Prepared By:

Joan, as director for ManBank, was approached by her friend Bob, requesting a loan to start a new airline business. Bob has determined that he would require a loan of $300,000.00 to begin this venture. Bob plans to use the planes he intends to purchase as collateral for the loan. Joan researches Bob’s background and identifies that he has worked in the industry for 12 years and was able to show an increase in regional sales by 28%. Based on this research and Joan’s personal friendship with Bob, Joan recommends that ManBank provide the full loan amount. The loan is granted and Bob begins his business. Within 3 years, Bob’s business goes bankrupt and the bank is only able to recover one half of the loan amount upon the sale of Bob’s planes. The bank is now responsible for a debt of $150,000.00 that they will not be able to recover. Due to this debt, the shareholders of ManBank file a derivative lawsuit against Joan for breach of her fiduciary duty of care.

The issue is to determine if Joan’s conduct is protected under the Business Judgment Rule (herein referred to as, BJR), thus, determining if Joan should be held liable for the company’s debt.

As outlined in the NPC courseware, the Business Judgment Rule does not provide for a distinct definition. It is a principle that it utilized by the courts in multiple applications and translations. Essentially, the BJR is a corporate protection for directors and officers of a firm who act in good faith and make prudent decisions on behalf of such firm; whereby, these directors and officers can not be held liable by the courts for “changes in the company’s circumstances or loss of value.”

Under NY CLS Bank, § 7015, “Each director of a bank… and loan association, when appointed or elected, shall take an oath that he will, so far as the duty devolves on him, diligently and honestly administer the affairs of such corporation, and will not knowingly violate, or willingly permit to be violated, any of the provisions of law applicable to such corporation.”

Under NY CLS Bank, § 717, the duty of directors is defined to say that a director shall perform its duties in good faith and with a degree of care which an “ordinarily prudent person” in a similar position would utilize in similar circumstances.

In Roselink Investors, L.L.C v. Shenkman, 386 F. Supp. 2d 209 (S.D.N.Y. 2004), creditors alleged that the defendants breached their fiduciary duties of due care, loyalty and good faith, by providing a loan from a subsidiary company to the parent company, rendering the subsidiary insolvent. This case defines the four elements of the BJR to be “1) a business decision; 2) disinterestedness and independence; 3) due care; and 4) good faith.” In such, it was noted that the BJR’s protection may be invoked as long as directors suffice their duty to inform themselves, prior to making a business decision of all material information that would be reasonably available to them. It also details that a board does not need to be aware of every fact or those that are immaterial or out of the Board’s reasonable reach. The Board provided several points of the research they conducted, prior to making the loan decision. It is not up to the Court to determine the wisdom of the decision itself. The shareholder’s also alleged that two of the directors had a personal interest in the benefit of the loan to the parent company, which would have been put at “grave risk” if the loan was not provided. It was noted that the creditors needed to show that the director’s interest was of a material nature. Additionally, in reference to the “good faith” element of the BJR, it was noted that inDelawarelaw “bad faith” is implied to be the “conscious doing of a wrong because of dishonest purpose or moral obliquity.” It was found that both directors were acting in the best interest of the parent company whereby the subsidiary company was the sole shareholder and thus acting in the best interest of the parent company’s shareholder. The courts determined that Board acted with sufficient diligence in their research and good faith prior to making their decision and ruled in favor of the defendant.

In Stephens v. National Distillers & Chem. Corp., 1996 U.S. Dist. LEXIS 6915 (S.D.N.Y. 1996), the insolvent company’s liquidator, was seeking summary judgment against the management defendants, arguing that the management defendants failed to act with due care prior to making decisions regarding the insolvent companies finances, although the company, at the time of these decisions was not insolvent. It was noted that the BJR will protect the substance of management’s decision as long as the process by which it was made meets that applicable standards of care. Liability may be imposed if the management failed to obtain material information or to make a “reasonable inquiry into material matters.” It was determined by the court that there was sufficient dispute over the facts to determine if management defendants failed to “provide reasonable care and perform in the manner that an ordinarily prudent person would” and that it would be necessary for the case to proceed in order for a judgment to be reached.

In FDIC v. Abel, 1995 U.S. Dist. LEXIS 18159, 23-25 (S.D.N.Y. 1995), defendant former officers and directors have filed a motion to dismiss the plaintiff’s claims for negligence, arguing they are protected under the BJR “absent an affirmative showing of fraud, bad faith, or self-dealing.” It was argued that it is insufficient to merely be dis-interested or indisposed to the breach of the duty of loyalty, as directors are held to a standard of due care, as well. This standard must be met with “conscientious fairness” and reasonable diligence in gathering and considering material information. The court confirmed that because the plaintiff has pled a lack of due diligence, it is sufficient to deny the defendants’ motion to dismiss. Additional reference in this case makes note that bank directors are held to a higher standard of care than non-bank directors. The court did not confirm this conclusion as it already based its decision to dismiss the motion based on the lack of due diligence.

In the case at hand, Joan, as a ManBank director, provided a recommendation to approve the $300,000.00 to her friend, Bob. Beyond the interest of friendship, Joan is not receiving any material benefit resulting from this loan. The facts provide that Joan did conduct research into Bob’s background prior to making her recommendation. Based on all of theNew Yorkcase law provided above, sufficient diligence in gathering “material information” is required to invoke protection under the BJR. The standard of this act is based on the standards of the ordinary prudent person, unless you look to the higher standards, of bank directors, as referenced in FDIC case. In theRoselink case, the board provided a detailed list of research that was conducted prior to making their decision, where as, Joan only researched Bob’s previous work history. Additionally, the shareholders have argued that Joan “should have known” the Bob’s venture would fail insinuating a “bad faith” decision was made on Joan’s part. As noted above, the shareholders would need to prove that Joan made a conscious decision to put the company at risk. It was also referenced that it is not a decision of the court to determine the wisdom of a decision and as such, if Joan felt she conducted sufficient research, prior to making her decision, the outcome of her decision would be invalid. As noted in the Stephens case, protection may be granted if there was a reasonable inquiry into material facts. Since we are aware that the collateral planes only provided one half of the loan amount, it could be noted that a “reasonable inquiry” was not made by Joan to determine the actual value of the planes. There is no reference in the facts that Joan made any type of inquiry into industry standards or the state of the airline industry. As in the FDIC case, since the shareholders have argued that Joan’s research was deficient and therefore lacked due diligence, it would require additional research and evidence in order to provide judgment.

Based on the facts provided and the current NY case laws referenced, Joan would not be protected under the Business Judgment Rule, because she made an uninformed business decision on behalf of the bank and its shareholders, based upon insufficient diligence in researching reasonable material information. The shareholders derivative action against Joan will, likely, succeed if they can prove that an ordinary prudent person in her position would have conducted additional research prior to making such decision, in accordance with the NY CLS Bank laws referenced above.