Appendix — Citytrust v. Joy

ang r —

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APPENDIX A

UNITED STATES COURT OF APPEALS

For Tue Seconp Circuit

No. 1050 — August Term, 1981

(Argued April 23, 1982 Decided November 4, 1982)

Docket No. 81-7729

ATHALIE Doris Joy,

Plaintiff-A ppellant,

—Y=

NELSON L. Nortu, Ropert C. BALDWIN, HERMAN K.

BACH. IR. EDWARD M. BLESER, PHILIP H. BURDETTE,

CAMERON CLARK, JR. WALTER M. GopDARD, RICHARD F.

GRETSCH, WILLIAM A, Haist, IR. EDWARD E. HARRISON,

WILLIAM C. KeaTor, CHARLES T. KELLOGG, Dr. HENRY W.

LITTLEFIELD, HUBERT T. MANDEVILLE, P. DoUGLAS MAR.

TIN, HORACE MERWIN, FREDERICK R. MILLER, WILLIAM R.

Moopy, Hoyt O. Perry, IR. WILLARD E. Rosperts, PHILIP

H. SAGARIN, NORMAN ScCHAFF, IR, CHARLES E. SPENCER,

III. Ret C. Spencer, HAROLD P. SPLAIN, FRANCIS W.

Srossk. DANIEL F. WHEELER, Ropert H. WHITNEY, Co-

NECTICUT FINANCIAL SERVICES, Corp., CITYTRUST, and

HAROLD H. GRISWOLD,

Defendants,

NELSON L. Nortu, Ropert C. BALDWIN, HERMAN K.

Beach, IR, Epwarp M. BLESER, Pümur H. BURDETTE,

CAMERON CLARK, IR. WALTER M. GopDArRD, RICHARD F.

Gretscu, WILLIAM A. Haist, IR. EDWARD E. HARRISON,

WILLIAM C. KeaTtor, CHARLES T. KELLOGG, DR HENRY W.

LITTLEFIELD, HUBERT T. MANDEVILLE, P. DoUGLAS Mak.

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TIN, WILLIAM R. Moopy, Hoyt O. Perry, IR. WILLARD E.

Roperts, Piu H. SAGARIN, CHARLES E. SPENCER, III.

HAROLD P. SPLAIN, DANIEL F. WHEELER, Ropert H.

WHITNEY, CONNECTICUT FINANCIAL SERVICES, CorpP.,

Citytrust, and HAROLD H. GRISWOLD,

Defendants-A ppellees.

Before:

OAKES, CARDAMONE, and WINTER,

Circuit Judges.

Appeal from a grant of summary judgment by the

United States District Court for the District of Connecticut

(Eginton, Judge), dismissing a shareholder's derivative suit

as to certain of the defendants on the basis of the report of a

special litigation committee and a decision to impose a pro-

tective order on the contents of the special litigation com-

mittee report.

Reversed and remanded.

A. REYNOLDS GorDON, Bridgeport, Connecticut (Arthur

A. Hiller, Lucille J. Becker, Gordon & Hiller, Bridge-

port, Connecticut, of counsel), for Appellant.

FRANCIS J. BRADY. Hartford, Connecticut (John S. Mur-

tha, Murtha, Cullina, Richter and Pinney, Hartford,

Connecticut, of counsel), for Appellees Citytrust and

Citytrust Bancorp, Ine.

Rall C. Dixon, Hartford, Connecticut (James L. Acker-

man, Felix J. Springer, Day, Berry & Howard, Hart-

ford, Connecticut, of counsel), for the nineteen

individually named Appellees.

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RicHarD F. LAWLER, Stamford, Connec.icut (Whitman

& Ranson, Stamford, Connecticut, of counsel), for

Appellee North.

J. DANIEL SAGARIN, Milford, Connecticut (Harrigan, Hur-

witz, Sagarin & Rutkin, Milford, Connecticut, of coun-

sel), for Appellee Sagarin.

Davip Mac.ay, Bridgeport, Connecticut, for Appellees

Connecticut Financial Services Corporation and City-

trust.

WILLIAM Secor, Waterbury, Connecticut, for Defendants

Miller and Kellogg.

WINTER, Circuit Judge:

This is an appeal from a grant of summary judgment for

defendants by the District Court for the District of Con-

necticut, Eginton, Judge, dismissing a derivative action

against certain directors and officers of Citytrust upon a

recommendation of a special litigation committee and plac-

ing that report under seal. 519 F.Supp. 1312 (D. Conn.

1981).

We reverse.

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BACKGROUND

In October of 1977, Dr. Athalie Doris Joy brought this

shareholder’s derivative suit on behalf of Connecticut

Financial Services Corporation (now Citytrust Bancorp,

Inc.) against its wholly-owned banking subsidiary, City-

trust,! and the officers and directors of Citytrust. Both cor-

porations are incorporated in Connecticut. The complaint

alleged diversity of citizenship, common law breach of

trust and of fiduciary duty as well as violations of the

National Bank Act, 12 U.S.C. § 84 (1976), which limits

aggregate loans to a single person or entity to 10% of a

bank’s combined stockholder equity and capital. The alle-

gations concern loans made by Citytrust to the Katz Corpo-

ration (“Katz”) for construction of an office building in a

redevelopment area of Norwalk, Connecticut. Plaintiff

seeks a $6 million recovery plus interest and attorney’s fees.

The underlying transactions need only be briefly sum-

marized at this point. In 1967, Citytrust entered into a 20-

year term lease agreement for approximately 9% of an

office building which Katz was planning to build in Nor-

walk. Katz, then a respected developer, signed a $4 million

construction mortgage for a one-and-a-half year term on

January 12, 1971. Although the mortgage was written

through and recorded in the name of Citytrust, Chase Man-

hattan Bank provided the bulk of the financing, $3.5 mil-

lion, with Citytrust participating to the extent of $500,000.

At this time, Katz had already borrowed, largely in unse-

cured form, an additional $250,000 from Citytrust to

finance construction of the office building. As the building

neared completion in early 1972, Katz had drawn down the

full value of the $4 million mortgage. At its expiration in

June, 1972, the Chase mortgage was replaced by a $4.5

million mortgage by First National City Bank, with

Citytrust both issuing the mortgage and participating to

1. Citytrust became a federal bank on June 30, 1971. It became a

state bank again on January 1, 1977.

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the extent of $90,000. Meanwhile, Katz continued to receive

unsecured loans from Citytrust. By December, 1972, that

unsecured debt reached $900,000, for a total of $990,000 in

Citytrust loans related to the building.

In June, 1973, with the building only half rented, the

First National City mortgage was extended for a year.

Katz’s unsecured debt to Citytrust had by now climbed to

$1,840,000. In November, in conjunction with the issuance

of yet another loan to Katz, Citytrust obtained a blanket

second mortgage on the building and on other Katz proper-

ties to secure what was now a total loan balance of

$2,140,000. Shortly thereafter, the First National City

mortgage was extended to August, 1975, and Citytrust lent

Katz another $300,000. Just prior to this extension of credit,

the National Bank Examiners classified the Katz loans.

In April, 1975, a refinancing plan was completed with

Lincoln National Life Insurance Company providing a $6

million loan to a Katz-related partnership which had taken

title to the building. The loan was secured by a first mort-

gage on the building and was used to consolidate Katz’s

debt. As a condition of the new financing, Citytrust was

required to take a 30-year master lease on the still largely

unrented building at a rental equaling the mortgage pay-

ments to Lincoln National, in effect guaranteeing Katz’s $6

million obligation to Lincoln. In addition to undertaking

the master lease, Citytrust had by now extended $2,665,000

in loans to Katz.

In May, 1975, the National Bank Examiners classified $2

million of the Katz loans as doubtful and required a charge

off of $665,000. On August 18, 1976, in an apparent effort to

salvage what was left of its position, Citytrust’s Board of

Directors authorized loans which exceeded the 10% federal

statutory limit. After these loans were consummated,

Katz’s total indebtedness to Citytrust reached $3,545,000.

On October 20, 1976, Citytrust charged off the $2 million

remaining on the second mortgage.

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On June 13, 1977, the Katz-related partnership relin-

quished title to the building to Citytrust in exchange for a

release from its obligation to Lincoln National and a release

of personal guarantees previously assumed by members of

the Katz family. Citytrust thus directly assumed the $6

million Lincoln National mortgage. In October, 1977,

Second Nutmeg Financial purchased the building for

$9,600,000 which consisted of its assumption of the $6 mil-

lion Lincoln National mortgage and a $3,600,000 note to

Citytrust secured by a second mortgage. There is an indica-

tion in the District Court record that an affiliate of Second

Nutmeg which later acquired the building has defaulted

and Citytrust once again owns it, along with the concurrent

obligations. There is no indication that rental income is now

adequate to meet those obligations, and we appear free to

assume that the other Katz properties covered by the

second mortgage are not of any significant value.

In October, 1977, Joy commenced this action after mak-

ing an unsuccessful demand on the Directors of Citytrust.

During the pendency of this case, the Supreme Court

decided Burks v. Lasker, 441 U.S. 741 (1979), holding that

federal courts must apply state law in determining the

authority of a committee of independent directors to discon-

tinue derivative suits even in many cases which arise under

federal law. Immediately following the Burks decision, the

Board of Directors of Citytrust and Connecticut Financial

Services Corporation authorized the establishment of a

Special Litigation Committee to determine whether con-

tinued prosecution of this derivative action would be in the

best interests of the corporation. The Committee consisted

of two Board members, Marion S. Kellogg and Ernest C.

Trefz.2 Kellogg was elected to the Board of Directors on

2. Alexander L. Stott was also named to the Committee. However, he

resigned on March 3, 1980.

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July 21, 1976 and commenced service on September 15,

1976. Trefz was elected to the Board on December 15, 1976

and commenced service on January 3, 1977. Neither is a

defendant in this action.*

By resolution dated August 15, 1979, the full Board of

Directors, a majority of whom were defendants, voted to

delegate to the Committee the power to review, investi-

gate and analyze the circumstances surrounding the

pending derivative action. The Committee retained inde-

pendent counsei, John Murtha, Esquire, to assist its

investigation.

Nine months later, the Committee issued a Report

recommending that the suit be discontinued as to 23

defendants, 20 of whom were outside directors of either

Citytrust or Connecticut Financial Services and three of

whom were either officers or directors or both. (The 23

will hereafter be referred to as the “outside defendants”).

The Committee concluded there was “no reasonable possi-

bility” that the outside defendants would be found liable.

Its Report also recommended that settlement be

considered with regard to seven defendants who were the

senior officers most directly involved in the Katz loans.

(These seven will hereafter be referred to as the “inside

defendants”). As to them, the Committee found there was

a “possibility” that one or more might be found to have

been negligent. Counsel for the Committee made it clear

to the District Court, however, that the decision to pursue

settlement was not necessarily a decision to press the lit-

igation against the inside defendants. If settlement is not

reached, the Committee will reconsider whether to recom-

mend termination of that portion of the action also.

3. Trefz and Kellogg did, however, vote to refuse plaintiff's demand

that the corporation bring suit against those involved in the Katz

transaction.

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When plaintiff declined to withdraw the action as to the

outside defendants, the corporation filed a motion to dis-

miss the case as to them. The District Court permitted

discovery on the limited issue of the Committee’s “bona

fides, motivation and thoroughness.” 519 F.Supp. at 1315.

Portions of the Committee Report, consisting of a sum-

mary and a detailed presentation of the Committee’s fac-

tual findings, supplemented by expert opinion letters and

counsel’s memorandum of law, were produced. These doc-

uments were put under seal pursuant to a protective

order. Plaintiff was also allowed to depose a variety of

persons involved in the underlying transactions and in

preparation of the Report, to pose interrogatories to oth-

ers, and to see various documents relating to the Report.

After discovery, Judge Eginton granted the defendants’

motion for summary judgment, the protective order

remaining in force. Concluding that no dispositive

Connecticut case or statute exists, Judge Eginton referred

to the weight of authority in cases reported elsewhere. He

held that Connecticut law permits the use of a Burks com-

mittee and that the business judgment rule limits judicial

scrutiny of its recommendations to the good faith, inde-

pendence and thoroughness of the Committee. 519 F. Supp.

at 1325. He resolved these issues favorably to the Commit-

tee and, therefore, entered summary judgment in favor of

the 23 outside defendants. Plaintiff appeals from the rul-

ing. We reverse as to both the grant of summary judgment

and the sealing of the Committee report.‘

4. The notice of appeal does not mention the protective order sealing

the Report although appellant has challenged it in her brief. Since

documents filed in this Court are being kept under seal pursuant to the

order, our power to vacate it is clear.

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DISCUSSION

The grounds of liability asserted are common law claims

of negligence and breach of fiduciary duty, as well as viola-

tion of the National Bank Act. We agree with Judge Egin-

ton for the reasons stated in his opinion that the Special

Litigation Committee may seek dismissal of both the state

common law and federal claims if Connecticut law autho-

rizes it to do so. 519 F. Supp. at 1318-22; Burks, supra. We

also agree with him that the Connecticut statutory and case

law cited by the parties is not dispositive. Our task, there-

fore, is to predict what the Connecticut Supreme Court

would do in a case such as the one before us.

Appellees assert that, since a board of directors can dele-

gate all its powers to a committee, Conn. Gen. Stat. Ann.

§ 33-318(a) (West 1982), a special litigation committee of

independent directors can decide whether a derivative

action should be dismissed or continued. They further

argue that, when an appropriate motion is made, courts

must defer to the committee’s recommendation under the

so-called business judgment rule, even though the delega-

tion of power is made by directors who are defendants in

the action. Judge Eginton adopted that position and limited

his inquiry to the Committee’s good faith, independence

and thoroughness. Appellees also assert that the Committee

Report in question may be kept under seal, any public use

being in violation of the District Court’s order. Appellant

claims an absolute right to maintain a derivative action

once begun and challenges the protective order on constitu-

tional and non-constitutional grounds.

An examination of these claims requires a discussion of

some underlying principles of corporate law. Our opinion

first addresses the nature and function of the business judg-

ment rule, which played a large role in persuading the

District Court to dismiss this action. It turns then to the

legal oddity known as the derivative action, thought by

many to be an endangered species as a consequence of the

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evolution of special litigation committees. See Comment,

Special Litigation Committees — An Expanding and Potent

Threat to Shareholder Derivative Suits, 2 Cardozo L. Rev.

169 (1980); Note, The Business Judgment Rule in Derivative

Suits Against Directors, 65 Cornell L. Rev. 600 (1980);

Dent, The Power of Directors to Terminate Shareholder Lit-

igation: The Death of the Derivative Suit, 75 Northwestern

L. Rev. 96 (1980). Finally, it discusses the general princi-

ples applicable to attempts by special litigation committees

to terminate particular derivative actions, and their rele-

vance to the present case.

A. The Liability of Corporate Directors and Officers and

the Business Judgment Rule

While it is often stated that corporate dii eetors and offi-

cers will be liable for negligence in carrying out their cor-

porate duties, all seem agreed that such a statement is

misleading. See generally, Lattin, Corporations, 272-75

(1971). Whereas an automobile driver who makes a mistake

in judgment as to speed or distance injuring a pedestrian

will likely be called upon to respond in damages, a corpo-

rate officer who makes a mistake in judgment as to eco-

nomic conditions, consumer tastes or production line

efficiency will rarely, if ever, be found liable for damages

suffered by the corporation. See generally, Symposium,

Officers’ and Directors’ Responsibilities and Liabilities, 27

Bus. Lawyer 1 (1971); Fever, Personal Liabilities of Corpo-

rate Officers and Directors, 28-42 (2d ed. 1974). Whatever

the terminology, the fact is that liability is rarely imposed

upon corporate directors or officers simply for bad judg-

ment and this reluctance to impose liability for unsuccess-

ful business decisions has been doctrinally labelled the

business judgment rule. Although the rule has suffered

under academic criticism, see, e.g., Cary, Standards of Con-

duct Under Common Law, Present Day Statutes and the

Model Act, 27 Bus. Lawyer 61 (1972), it is not without

rational basis.

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First, shareholders to a very real degree voluntarily

undertake the risk of bad business judgment. Investors

need not buy stock, for investment markets offer an array

of opportunities less vulnerable to mistakes in judgment by

corporate officers. Nor need investors buy stock in particu-

lar corporations. In the exercise of what is genuinely a free

choice, the quality of a firm’s management is often decisive

and information is available from professional advisors.

Since shareholders can and do select among investments

partly on the basis of management, the business judgment

rule merely recognizes a certain voluntariness in undertak-

ing the risk of bad business decisions.

Second, courts recognize that after-the-fact litigation is a

most imperfect device to evaluate corporate business deci-

sions. The circumstances surrounding a corporate decision

are not easily reconstructed in a courtroom years later,

since business imperatives often call for quick decisions,

inevitably based on less than perfect information. The

entrepreneur’s function is to encounter risks and to con-

front uncertainty, and a reasoned decision at the time made

may seem a wild hunch viewed years later against a back-

ground of perfect knowledge.

Third, because potential profit often corresponds to the

potential risk, it is very much in the interest of shareholders

that the law not create incentives for overly cautious corpo-

rate decisions. Some opportunities offer great profits at the

risk of very substantial losses, while the alternatives offer

less risk of loss but also less potential profit. Shareholders

can reduce the volatility’ of risk by diversifying their hold-

ings. In the case of the diversified shareholder, the seem-

ingly more risky alternatives may well be the best choice

since great losses in some stocks will over time be offset by

5. For purposs of this opinion, “volatility” is “the degree of dispersion

or variation of possible outcomes.” Klein, Business Organization and

Finance 147 (1980).

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even greater gains in others.“ Given mutual funds and sim-

ilar forms of diversified investment, courts need not bend

over backwards to give special protection to shareholders

who refuse to reduce the volatility of risk by not diversify-

ing. A rule which penalizes the choice of seemingly riskier

alternatives thus may not be in the interest of shareholders

generally.

6. Consider the choice between two investments in an example

adapted from Klein, Business Organization and Finance 147-49

(1980):

INVESTMENT A

Estimated Outcome

Probability Profit or

of Outcome Loss Value

A +15 6.0

A +1 A

_2 -13 20

1.0 3.8

INVESTMENT B

Estimated Outcome

Probability Profit or

of Outcome Loss Value

A +6 2.4

4 +2 8

4 4 st

1.0 3.4

Although A is clearly “worth” more than B, it is riskier because it is

more volatile. Diversification lessens the volatility by allowing inves-

tors to invest in 20 or 200 A's which will tend to guarantee a total result

near the value. Shareholders are thus better off with the various firms

selecting A over B, although after the fact they will complain in each

case of the 2.6 loss. If the courts did not abide by the business judgment

rule, they might well penalize the choice of A in each such case and

thereby unknowingly injure shareholders generally by creating incen-

tives for management always to choose B.

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Whatever its merit, however, the business judgment rule

extends only as far as the reasons which justify its exis-

tence. Thus, it does not apply in cases, e.g., in which the

corporate decision lacks a business purpose, see Singer v.

Magnavox, 380 A.2d 969 (Del. Supr. 1977), is tainted by a

conflict of interest, Globe Woolen v. Utica Gas & Electric

Co., 224 N.Y. 483, 121 N.E. 378 (1918), is so egregious as to

amount to a no-win decision, Litwin v. Allen, 25 N.Y.S.2d

667 (N.Y. Co. Sup. Ct. 1940), or result from an obvious and

prolonged failure to exercise oversight or supervision,

McDonnell v. American Leduc Petroleums, Lid., 491 F.2d

380 (2d Cir. 1974); Atherton v. Anderson, 99 F. 2d 883 (6th

Cir. 1938). Other examples may occur.

B. Shareholder Derivative Actions

Whereas ordinary lenders may and will sue directly to

enforce their rights and debentureholders look to indenture

trustees to enforce obligations to them, direct actions by

individual shareholders for injuries to the value of their

investment would be an inefficient and wasteful method of

enforcing management obligations. The stake of each

shareholder in the likely return is usually too small to jus-

tify bringing a lawsuit and a multiplicity of such actions

would result in corporate and judicial waste. Moreover, the

costs of organizing a large number of geographically

diverse shareholders to bring an action are usually prohibi-

tively high. If an alternative remedy were not available,

therefore, the fiduciary obligations of corporate manage-

ment, however limited, might well be unenforceable.

Moreover, state or federal law may impose other duties

upon directors and officers which are designed to protect

shareholders through procedural or other requirements,

e.g. proxy rules. Enforcement of such obligations by share-

holders, even where monetary recovery by the corporation

is doubtful, may be desirable. J.J. Case Co. v. Borak, 377

U.S. 426 (1964); Mills v. Electric Auto-Lite, 396 U.S. 375

(1970).

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The derivative action is the common law’s inventive solu-

tion to the problem of actions to protect shareholder inter-

ests. In its classic form, a derivative suit involves two

actions brought by an individual shareholder: (i) an action

against the corporation for failing to bring a specified suit

and (ii) an action on behalf of the corporation for harm to it

identical to the one which the corporation failed to bring.

See Ross u. Bernhard, 397 U.S. 531 (1970). The technical

structure of the derivative suit is thus quite unusual.

Moreover, the shareholder plaintiffs are quite often little

more than a formality for purposes of the caption rather

than parties with real interest in the outcome. Since any

judgment runs to the corporation, shareholder plaintiffs at

best realize an appreciation in the value of their shares. The

real incentive to bring derivative actions is usually not the

hope of return to the corporation but the hope of handsome

fees to be recovered by plaintiffs’ counsel. As two leading

commentators state:

[The derivative action constitutes a major bulwark

against managerial self-dealing. As a practical matter

this means that the rules governing plaintiffs’ legal fees

are critical to the =} of the corporate system:

Since very few shareholders would pay an attorney’s fee

out of their own pocket to finance a suit that is brought

on the corporation’s behalf and normally holds only a

slight and indirect benefit for the plaintiff, very few

derivative actions would be brought if the law did not

allow the plaintiff's attorney to be compensated by a

contingent fee payable out of the corporate recovery.

Cary and Eisenberg, Corporations 938 (5th ed. 1980).

However, there is a danger in authorizing lawyers to

bring actions on behalf of unconsulted groups. Derivative

suits may be brought for their nuisance value, the threat of

protracted discovery and litigation forcing settlement and

payment of fees even where the underlying suit has modest

merit. Such suits may be harmful to shareholders because

the costs offset the recovery. Thus, a continuing debate sur-

rounding derivative actions has been over restricting their

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use to situations where the corporation has a reasonable

chance for benefit.

C. Termination of Derivative Suits Special Litigation

Committees

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 (1917). Thus, share-

holders 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 direc-

tors’ decision will be conclusive unless bad faith is proven.

Different rules apply, however, in the cases which prim-

arily concern us here. When there is a conflict of interest in

the directors’ decision not to sue because the directors them-

selves have profited from the transaction underlying the

litigation or are named defendants, no demand need be

made and shareholders can proceed directly with a deriva-

tive 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 spe-

cial litigation committee plays its role.

Appellees argue that, because special litigation commit-

tees 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-not-required

cases. If that proposition were accepted, the business judg-

ment 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

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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.

We believe Connecticut would not adopt appellees’ con-

tention that the business judgment rule should play a major

role where a special litigation committee recommends ter-

mination of an action in a demand-not-required case, such

as the one before us.’ As a practical matter, new board

members are selected by incumbents. The reality is, there-

fore, that special litigation committees 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 recom-

mendation of termination at least as to them, they would

probably never establish the committee.“ The conflict of

interest which renders the business judgment rule inappli-

cable in the case of directors who are defendants is hardly

eliminated by the creation of a special litigation committee.

7. Demand was made in the present case but was not required as a

condition of bringing the action.

8. We do not regard the Committee's failure to recommend dismissal

as to the seven inside defendants as affecting this conclusion. First, most

of the seven appear to have severed their relationship with Citytrust.

Second, the Committee will reconsider their recommendation if settle-

ment efforts fail. Finally, the facts here are such that the Committee

might reasonably have feared that such a recommendation at this stage

would have destroyed its credibility.

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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’ crea-

tion 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 Conr.. 199,

208-09, 429 A.2d 850, 854 (1980) and cases cited therein. To

be sure, Judge Cardamone is correct in anticipating diffi-

culties in judicial review of the recommendations of special

litigation committees. These difficulties are not new, how-

ever, but have confronted every court which has scrutin-

ized the fairness of corporate transactions involving a

conflict of interest.

Moreover, the difficulties courts face in evaluation of bus-

iness decisions are considerably less in the case of recom-

mendations 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 law-

suit 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 defen-

dants would be held liable. A court is not ill-equipped to

review the merits of that conclusion. Even when the Com-

mittee 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 corpo-

rate treasury, courts are not on unfamiliar terrain. The

rule we predict Connecticut would establish emphasizes

matters such as probable liability and extent of recovery.

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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.

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’ capi-

tal 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 elim-

inated 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 substan-

tially 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 judi-

cial findings of adequate representation of shareholders

and approval of settlements. See Conn. Gen. Stat. Ann.

§ 52-572j (West 1982). Appellees’ view essentially vests

power in defendants’ appointees to bring about their

dismissal.

A-19

We are aware that Auerbach v. Bennett, 47 N.Y.2d 619,

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 pre-

dict 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.

We detect no signals that Connecticut law is moving

away from the enforcement of directors’ and officers’ tradi-

tional fiduciary obligations. Connecticut legislation govern-

ing indemnification of directors and officers for expenses

incurred in litigation supports the view we take here. Conn.

Gen. Stat. Ann. § 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 can-

not be varied by corporate by-laws. It calls for indemnifica-

tion 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 indemnifica-

tion without regard to outcome and thus does not bespeak a

negative attitude toward enforcement of fiduciary obliga-

tions through meritorious derivative litigation.

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

A-20

well be brought which cannot be dismissed on motion but

which also are unlikely to lead to net benefits to the corpora-

tion. At least where the effectuation of an overriding fed-

eral 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 alleg-

ing federal proxy violations), a corporation can play a legiti-

mate role in aiding a court to determine whether the

maintenance of an action in its name is in fact in its inter-

est. Surviving a motion to dismiss and for summary judg-

ment 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.

Appellant argues that Connecticut recognizes an abso-

lute right to bring and continue a derivative action. The

statute relied upon, however, Conn. Gen. Stat. Ann. § 52-

5723.“ clearly of a procedural nature directing how and

9. Section 52-572j reads in part:

(a) Whenever any corporation or any unincorporated association fails

to enforce a right which may properly be asserted by it, a derivative

action may be brought by one or more shareholders or members to

enforce such right, provided such shareholder or member was a share-

holder or member at the time of the transaction of which he complained

or his membership thereafter devolved on him by operation of law. Such

action shall be begun by a complaint returnable to the superior court for

the county or judicial district in which an office of the corporation or

association is located. The derivative action may not be maintained if it

appears that the plaintiff does not fairly and adequately represent the

interests of the shareholders or members similarly situated in enforcing

the right of the corporation or association. The action shall not be dis-

missed or compromised without the approval of the court, and notice of

the proposed dismissal or compromise shall be given to shareholders or

members in such manner as the court directs.

(b) In any action brought pursuant to this section, process shall also

be served on the corporation or association as in other civil actions, and

notice of such service of process after its having been served shall be

given to the board of directors and such other interested persons as the

court deems proper, and it shall not be necessary to make shareholders

A-21

where such actions may be brought in a state court. It has

no apparent substantive effect. Appellant also relies upon

Conn. Gen. Stat. Ann. § 33-323 (West 1982)'° which renders

transactions between the corporation and directors void-

able 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 deci-

sion permits dismissal of this action only after an indepen-

dent judicial finding that it will not benefit the corporation,

the statutory fairness requirement is satisfied.

The Connecticut statute permitting indemnification with

court approval of a director’s expenses incurred in defend-

ing litigation even when the settlement calls for payment to

the corporation, Conn. Gen. Stat. Ann. § 33-320a(b), sug-

gests a recognition by the General Assembly of the fact that

some derviative actions may in the end not benefit the cor-

poration. We believe Connecticut law allows a court before

or members parties thereto. The costs of such action or part thereof,

which shall include but not be limited to witness’ fees, court costs and

reasonable attorney's fees, may be charged by the court, in its discre-

tion, against the corporation.

10. Section 33-323 reads in part:

(a) A contract or transaction between a corporation and a director

thereof, or a member of his immediate family, or between a corporation

and any other corporation, firm or other organization in which a direc-

tor of the corporation and members of his immediate family have an

interest, shall not be voidable and such director shall not incur any

liability, merely because such director is a party thereto or because of

such family relationship or interest, if: (1) Such family relationship or

such interest, if it is a substantial interest, is fully disclosed, and the

contract or transaction is not unfair as to the corporation and is autho-

rized by (i) directors or other persons who have no substantial interest

in such contract or transaction in such a manner as to be effective

without the vote, assent or presence of the director concerned or (ii) the

written consent of all of the directors who have no substantial interest in

such contract or transaction, whether or not such directors constitute a

quorum of the board of directors.

A-22

which a derivative action is pending to entertain a motion

for judgment by a defendant corporation based on a recom-

mendation of a special litigation committee. Before grant-

ing 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 dismis-

sal but which also may not benefit the corporation, the

device of the special litigation committee affords an oppor-

tunity 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 recommenda-

tion is to determine independently whether the action is

likely to harm the corporation rather than help it.

We strongly disagree with the implications of the dissent-

ing 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 law-

suits.” 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 conclu-

sive 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.

A-23

The Auerbach decision gives excessive weight to the

recommendations of special litigation committees. In re-

jecting 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 can-

not 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 com-

mittee 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.

Independent judicial scrutiny of a special litigation com-

mittee’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

Life, supra (action for misleading proxy statement where

no monetary recovery by the corporation may result); Bosch

A-24

v. Meeker Cooperative Light & Power Assn., 275 Minn. 362,

101 N.W.2d 423 (1960) (invalidation of directors’ elections).

The guidelines we establish here are limited to cases involv-

ing 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 corpo-

ration in ways other than the recovery of compensatory

damages.

In cases such as the present one, the burden is on the

moving party, as in motions for summary judgment gener-

ally, 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 conclu

sions. The weight to be given certain evidence is to be deter-

mined 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 appro-

priate 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 lawy-

er's determining what a case is “worth” for purposes of

settlement.

Where the court determines that the likely recoverable

damages discounted by the probability of a finding of liabil-

ity 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

oF a

?

A-25

out-of-pocket expenses related to the litigation and time

spent by corporate personnel preparing for and participat-

ing in the trial. The court should also weigh indemnifica-

tion 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 indemnifi-

cation the corporation may later pay as a matter of discre-

tion 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.

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 lit-

igation. Second, it may take into account potential lost prof-

its which may result from the publicity of a trial.

Judicial scrutiny of special litigation committee recom-

mendations 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 elu-

siveness 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.

We do recognize two exceptions, however. First, where

the likely net return is not substantial in relation to share-

holder equity, the court can consider the degree to which

key personnel may be distracted from corporate busi‘iess

A-26

by continuance of the litigation. We appreciate that litiga-

tion 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.

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 busi-

ness 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 the alleged

experts, e., verifiable examples in similar firms.

D. Procedural Issues

Review of special litigation committee reports also raises

a number of procedural issues. First, documents used by

parties moving for, or opposing, summary judgment should

not remain under seal absent the most compelling reasons.

Fed. R. Civ. P. 26(c) authorizes protective orders in the

course of discovery, “[a]n important purpose of [which] is to

preserve the confidentiality of materials which are

revealed in discovery but not made public at trial.”

National Polymer Products v. Borg-Warner Corp., 641 F.2d

A-27

418, 424 (6th Cir. 1981). Protective orders are useful te pre-

vent discovery from being used as a club by threatening

disclosure of matters which will never be used at trial. Dis-

covery involves the use of compulsory process to facilitate

orderly preparation for trial, not to educate or titillate the

public. Private matters which are discoverable may, upon a

showing of cause, be put under seal under Rule 26(c), in the

first instance. Martindale v. International Tel. & Tel. Corp.,

594 F.2d 291 (2d Cir. 1979), says no more than that.

At the adjudication stage, however, very different consid-

erations apply. An adjudication is a formal act of govern-

ment, the basis of which should, absent exceptional

circumstances, be subject to public scrutiny. We simply do

not understand the argument that derivative actions may

be routinely dismissed on the basis of secret documents. We

cannot say what the effect on investor confidence would be

if special litigation committees were routinely allowed to do

their work in the dark of night. We believe, however, that

confidence in the administration of justice would be

severely weakened. Indeed, any other rule might well

create serious constitutional issues. See Globe Newspaper

Co. v. Superior Court, 50 U.S.L.W. 4759 (U.S. June 23,

1982).

We do not say that every piece of evidence, no matter how

tangentially related to the issue or how damaging to a party

disclosure might be, must invariably be subject to public

scrutiny. An exercise of judgment is in order. The impor-

tance of the material to the adjudication, the damage disclo-

sure might cause, and the public interest in such materials

should be taken into account before a seal is imposed.

Second, if the special litigation committee recommends

termination and a motion for judgment follows, the com-

mittee must disclose to the court and the parties not only its

report but all underlying data. To the extent that communi-

cations arguably protected by the attorney-client privilege

may be involved in that data, a motion for judgment based

A-28

on the report waives the privilege.'' See In re John Doe

Corporation, 675 F.2d 482 (2d Cir. 1982). The work-product

immunity will apply to the documents usually included

within its terms to the extent that they are working papers

of the committee’s counsel and are not communicated to the

committee. Once communicated, the immunity may not be

claimed, since the papers may be part of the basis for the

committee’s recommendations.

E. The Present Case

Given the principles outlined above, we reverse the order

putting the Citytrust Committee’s Report under sea! and

restricting its use. The showing of good cause was merely

that it and the accompanying documents were protected by

the attorney-client privilege and work-product immunity

and involved a candid assessment of the bank’s internal

operations which, if made public, would adversely affect

the two corporations in the banking industry and the

Bridgeport community. This showing is patently inade-

quate. First, the submission of materials to a court in order

to obtain a summary judgment utterly precludes the asser-

tion of the attorney-client privilege or work-product

immunity. Second, a naked conclusory statement that pub-

lication of the Report will injure the bank in the industry

and local community falls woefully short of the kind of

showing which raises even an arguable issue as to whether

it may be kept under seal. The Report is no longer a private

document. It is part of a court record. Since it is the basis

for the adjudication, only the most compelling reasons can

justify the total foreclosure of public and professional seru-

tiny. The potential harm asserted by the corporate defen-

dants is in disclosure of poor management in the past. That

is hardly a trade secret. The argument that disclosure of

poor management is so harmful as to justify keeping the

11. Whether or to what extent the attorney-client privilege applies to

material relating to creation of the Special Litigation Committee is an

issue we do not decide.

A-29

Report under seal proves too much since it is a claim which

grows stronger with the degree of misconduct. Were out-

right looting of Citytrust disclosed by the Report, for exam-

ple, the harm of publication would be even greater.

Moreover, Citytrust is a publicly owned company and this

litigation directly concerns management's obligations to

shareholders. We believe that foreclosing public scrutiny of

the grounds for this adjudication is wholly unjustifiable.

We turn now to the contents of the Special Litigation

Committee’s Report. We emphasize that this recitation is

the Committee’s version of the facts. The record suggests

that a trial might reveal sharply differing versions of the

same events from various witnesses as well as sharply

differing inferences drawn from that testimony.

According to the Report, Nelson L. North was City-

trust’s Chief Executive Officer and Norman Schaff, Jr.

was its Chief Lending Officer during the period in ques-

tion. The management of Citytrust was completely domi-

nated by North. Bank officers who did not temper

themselves to his regime had a short tenure at the bank.

North also exercised strong control over the activities of

the Board of Directors. Board members were given

neither materials nor agendas prior to meetings and

requests for long range planning documents were left

unanswered. North’s control is illustrated by the fact that

contrary to the recommendation of Citytrust’s outside

auditors, the bank’s Audit Committee was not composed

solely of outside directors but instead counted among its

members Mr. North and one other officer. Minutes of the

Audit Committee between 1971 and 1974 are largely

incomplete.

Mr. North apparently brought the initial proposal for

the Katz loan to Citytrust. From 1971 to 1976, North’s son

was employed by Katz, and he apparently deemed this a

sufficient conflict of interest to preclude his voting on the

Katz transactions in Executive Committee meetings. This

A-30

fastidiousness appears to have been limited to the formal-

ity of voting, for the Report strongly suggests that North

was deeply involved in the Katz transactions, although the

full degree of his involvement is left uncertain. The

Report also adds that Mr. North has destroyed his

records.

Katz appears to have been experiencing financial diffi-

culties as early as 1971. Chase Manhattan in fact opposed

financing the Katz building in part because of a $1.6 mil-

lion shortfall between the building cost and available

lending; it was North who persuaded Chase to make the

initial mortgage loan. By 1972, Katz was falling behind in

its loans and by December of that year owed Citytrust

$990,000 with respect to the building. The Report con-

cludes that by then Citytrust was effectively a joint ven-

turer with Katz in the building, sharing the risk of loss

but entitled at best only to interest and principal if things

went well. There is also some indication that a portion of

the unsecured advance made by Citytrust was being ap-

plied to the Chase mortgage.

Notwithstanding the increasingly evident peril in City-

trust’s transactions with Katz, no appraisals of the build-

ings were undertaken until 1976, and no rentability study

until 1974. Although Katz had suggested that a public

offering would alleviate the situation, no professional

review of the preliminary prospectus was undertaken.

From 1972 through 1973, only one meeting of the Board of

Directors or Executive Committee considered the Katz

loans. The Senior Loan Committee did meet on the Katz

matter late in 1972 and may have adopted a very cautious

attitude toward further credit extension. Despite this, and

despite the absence of Executive Committee and Board

support, senior management extended almost a million

dollars in loans to Katz between 1972 and 1973.

From 1973 through 1974, the number of Board meet-

ings at which the Katz loans were considered increased to

=, ee

A-31

five. This is roughly contemporaneous with the recom-

mendation of the outside auditors that a 50% special fund

be set up for the Katz loans and the National Bank Exam-

iners’ classification of the total outstanding Katz

indebtedness as substandard. It is, as the Report notes,

“unsettling” that neither Schaff nor Citytrust’s Comp-

troller recall being advised of the recommendation as to

the special reserve. Moreover, it is not established that the

Directors were advised of this recommendation.

By late 1974, the Katz loans were so clearly a problem

that they were extensively considered by the Board and

the Executive Committee. In fact, the Report notes that

these loans were discussed at a minimum of 25 Board and

Executive Committee meetings. Nevertheless, when, on

August 18, 1976, the Board was presented with the

request to go over the 10% limit, there was no prior men-

tion of the issue on the agenda nor was opinion of counsel

presented to the Board or even sought. Indeed, copies of

the Comptroller’s letter suggesting that Directors might

wish to consult their personal counsel were not distrib-

uted to the Board.

The Report estimates a loss of $5.1 million to Citytrust.

As stated earlier, there is an indication in the record that

since the Report was issued, the new owner has defaulted

and Citytrust again owns the building. If so, $5.1 million

may be considerably less than the actual loss. In any

event, a loss exceeding 10% of shareholder equity seems

quite likely.

A-32

The Report contains the opinions of two experts. One con-

cluded that the impact on morale of bank personnel, on the

image of Citytrust among the banking public, upon persons

who might be asked to become directors and upon potential

new customers would offset even a recovery of $5.5 mil-

lion.'? The other reached a different conclusion, stating that

a recovery of even $2 million would be worth pursuing not-

withstanding speculation about the public impact. It stated

that this opinion would stand whether or not the outside

directors continue as defendants, “as long as the insurance

carrier is obligated through the ‘D and O policy’.” This last

phrase might have given the Committee some pause since

the letter requesting the opinion indicated that the insur-

ance carrier had raised a question as to its liability.

As to exceeding the federal statutory limit, the Commit-

tee concluded that under the compelling circumstances sur-

rounding the vote, it is possible that no net damage to

Citytrust resulted. It also concluded that even if damage

did occur, the maximum recovery would be $376,000 plus

interest, a sum too small in the Committee’s view to justify

continuance of the action.

As to the claims of breach of fiduciary duty, the Commit-

tee recommended that the suit be discontinued as to the

outside defendants because there is “no reasonable possibil-

ity” that they might be found liable. As to the others, it

concluded merely that

there is a possibility that a finding of negligence could

be rendered against any one or more of the senior loan

officers who participated in the Katz Corporation loans.

12. This opinion was not substantiated by verifiable historical evi-

dence or other factual material. As such, we believe it is entitled to no

weight in the determination whether a suit such as this should be

dismissed.

13. If in fact the potential recovery was limited to $376,000, the

analysis described above might well lead to a dismissal.

A-33

Although it is emphasized that there is no evidence

whatsoever of any self-dealing or of deliberate

impropriety, there is some indication that the most pru-

dent lendin lags 4 were not adhered to during the

evolution of those loans.

Applying the standard of review set out above to the

Committee’s recommendation, we look first to potential lia-

bility generally without regard to which defendants are

responsible. As to that liability, we find that plaintiff's

chances of success are rather high. The loss to Citytrust

resulted from decisions which put the bank in a classic “no

win” situation. The Katz venture was risky and increas-

ingly so. By continuing extensions of substantial amounts of

credit the bank subjected the principal to those risks

although its potential gain was no more than the interest it

could have earned in less risky, more diversified loans. In a

real sense, there was a low ceiling on profits but only a

distant floor for losses. It is so similar to the classic case of

Litwin v. Allen, supra (bank purchase of bonds with an

option in the seller to repurchase at the original price, the

bank thus bearing the entire risk of a drop in price with no

hope of gain beyond the stipulated interest) that we cannot

agree with the Committee’s conclusion that only a “possibil-

ity of a finding of negligence” exists.

The issue as to which defendants are responsible is less

clear. The Committee concluded that there is “no reason-

able possibility” of the outside defendants being found lia-

ble because they had neither information nor reasonable

notice of the problems raised by the Katz transactions. We

note first that members of the inside defendants may con-

tradict that version and, if so, a possibility of liability in

the outside group exists. Moreover, lack of knowledge is

not necessarily a defense, if it is the result of an abdication

of directorial responsibility. McDonnell, supra; Atherton,

supra. Directors who willingly allow others to make

major decisions affecting the future of the corporation

wholly without supervision or oversight may not defend

*

ive

A-34

on their lack of knowledge, for that ignorance itself is a

breach of fiduciary duty. The issue turns in large part

upon how and why these defendants were left in the dark.

See Graham v. Allis Chalmers Mfg. Co., 41 Del. Ch. 78, 188

A.2d 125 (1963). An individual analysis of each outside

defendant’s role may show that some are blameless or

even that they all were justified in not acting before they

did, but neither is an inexorable conclusion on the basis of

the present record.

The Report concluded as to the inside defendants that

there was a “possibility” of liability. This conclusion is a

considerable understatement and not entirely consistent

with the Report’s finding as to the outside defendants. The

outsiders’ best defense may well be that the inside group

actively concealed the Katz problem. Given the fact that

exoneration of the outside defendants may show culpabil-

ity of the insiders and our conclusion that the probability

of liability somewhere is high, we think the exposure of

the inside group is considerably more than a “possibility.”

Nor do we agree that “there is no evidence whatsover” of

deliberate impropriety. Not only is there the problem of

North’s apparently inconsistent behavior with respect to

the appropriateness of his participation in the considera-

tions of Katz transactions, but his failure to keep the

Board of Directors informed may well entail more than a

negligent omission.

A precise estimate of potential damages is not possible

since the trier must determine at what point liability be-

gins. We think, however, that on the present record, a

trier might easily find liability extending back to early

1972 or before (assuming no statute of limitations prob-

lem), resulting in a return of several million dollars to

Citytrust, or perhaps 10% or more of the shareholder

equity. This far exceeds the potential cost of the litigation

to the corporation.

A-35

CONCLUSION

Applying the analysis described above, we conclude that

the probability of a substantial net return to the corpora-

tion is high. We reject, therefore, the recommendation of

the Special Litigation Committee. The grant of summary

judgment is reversed, the protective order is vacated, and

the case is remanded. Since we have been unable to explain

our reasoning in this opinion without extensive reference to

materials under seal, the mandate shall issue forthwith as

to the lifting of the protective order.“

CARDAMONE, C.J., concurring, in part,! and dissenting in

part.

As the majority correctly concludes Connecticut law con-

trols the question of the defendant corporation’s right to

terminate Joy’s derivative suit. Since Connecticut’s courts

have not yet addressed the issue now before us, we are

relegated to predicting what the Connecticut Supreme

Court would decide in this case. Because it is an “iffy” busi-

ness to prophesy what view a state’s highest court will take

in the future, and since Connecticut's Supreme Court could

at any time render what we say here irrelevant, the discus-

sion should be as simple as possible.

The highest courts of only two states have addressed the

question currently before us. In Auerbach w. Bennett, 47

N. V. 24 619 (1979), New York’s Court of Appeals held that

the substantive merits of an independent director commit-

tee’s decision to terminate derivative litigation against

defendant corporate directors are beyond judicial scrutiny

14. We do not disturb that portion of the protective order which pro-

tects the confidentiality of the Committee’s evaluation of the settlement

value of the litigation. It is not relevant to the issues before us.

1. I concur with the majority insofar as it vacates the order placing the

independent committee report under seal.

A-36

and that a court’s role in such cases is limited to determin-

ing whether the committee acted independently, tho-

roughly and in good faith. In so holding, the A uerbuch court

recognized and applied the business judgment doctrine

which it stated “bars judicial inquiry into actions of corpo-

rate directors taken in good faith and in the exercise of

honest judgment in the lawful and legitimate furtherance

of corporate purposes.” Id. at 629. In Zapata Corp. v. Mal-

donado, 430 A. 2d 779 (Del. 1981), the Delaware Supreme

Court expressly refused to adopt the business judgment

rationale. Instead it fashioned a two-step analysis. Under

the first, which mirrors Auerbach, the corporation seeking

dismissal must establish the independence, good faith and

thoroughness of the investigative efforts of the committee of

the board reaching the decision to terminate the litigation.

As a second step the trial court in its discretion may apply

its own “independent business judgment” in determining

whether to accept the board’s decision to terminate the

derivative suit.

Faced with these opposing views, the majority has con-

cluded that Connecticut would not adopt the “business judg-

ment” doctrine of Auerbach, but would adopt the

“independent business judgment” test of Maldonado. In

fact, the majority goes beyond Maldonado by requiring

that the court must proceed to apply its own business judg-

ment, rather than leaving the decision to resort to the

second step within the trial court’s discretion. I respectfully

dissent from that conclusion and propose, first, to set forth

briefly what I perceive to be the inherent deficiencies in

Maldonado and the adoption of its rationale by the majority

and, then, to indicate why I believe the Connecticut

Supreme Court will take a position similar to Auerbach.

Under Maldonado two-step analysis and the majority

position unanswered questions abound. For example,

A-37

reasonable inquiry could be made with regard to the follow-

ing: under what circumstances can the trial court conclude

that the director’s decision satisfied the step one criteria,

but not the “spirit” of those criteria as required by step two

of Maldonado; will evidence be considered by the court that

was not before the independent committee; in the exercise

of its “business judgment” will the court consider facts not

in the record; will the court need to appoint its own experts?

The majority proposes a calculus in an attempt to resolve

additional issues engendered by its analysis. This calculus

is so complicated, indefinite and subject to judicial caprice

as to be unworkable. For example, how is a court to deter-

mine the inherently speculative costs of future attorneys’

fees and expenses related to litigation, time spent by corpo-

rate personnel preparing for trial, and mandatory indemni-

fication “discounted of course by the probability of liability

for such sums.” How is a court to quantify corporate good-

will, corporate morale and “the distraction of key person-

nel” in cases in which it “finds a likely net return to the

corporation which is not substantial in relation to share-

holder equity?” Should a court also take into account the

potential adverse impact of continuing litigation upon the

corporation’s ability to finance its operations? Should

future costs be discounted to present value and, if so, at

what rate? Must the income tax ramifications of expected

future costs be considered and, if so, how? This veritable

Pandora’s box of unanswered questions raises more prob-

lems than it solves.

Even more fundamentally unsound is the majority's

underlying premise that judges are equipped to make busi-

ness judgments. It is a truism that judges really are not

equipped either by training or experience to make business

judgments because such judgments are intuitive, geared to

risk-taking and often reliant on shifting competitive and

market criteria. Auerbach, 47 N.Y.2d at 630 (courts are

“ill-equipped” to make essentially business judgments).

on

A-38

Reasons of practicality and good sense strongly suggest

that business decisions be left to businessmen. Whether to

pursue litigation is not a judicial decision, rather, it is a

business choice. Burks v. Lasker, 441 U.S. 471, 487 (1979)

(Stewart, J., concurring) (“A decision whether or not a cor-

poration will sue an alleged wrongdoer is no different from

any other corporate decision ....”). As perceptive com-

mentators have observed, if Maldonado’s statement is true

that “{uJnder our system of law, courts and not litigants

should decide the merits of litigation,” Maldonado at 789

n.13 (quoting Maldonado v. Flynn, 413 A.2d 1251, 1263

(Del. Ch. 1980)), then its corollary “that boards, and not

courts, are entitled to exercise business judgment” is

equally true. Coffee and Schwartz, The Survival of the

Derivative Suit: “An Evaluation and a Proposal for Legisla-

tive Keform, 81 Colum. L. Rev. 261, 329 (1981).

Public policy concerns also strongly militate against the

second step of the majority’s two-tiered analysis. The sud-

den urge for stricter corporate accountabilty under judicial

aegis arises, one Connecticut commentator suggests, not

from corporate misconduct, which he asserts is no greater

now than at previous times in history but, rather, because

of an anti-business bias present in our society amidst an

atmosphere of pervasive government regulation. Wolfson,

A Critique of Corporate Law, 34 U. Miami L. Rev. 959,

988-89 (1980). In a land weary of overregulation and the

kind of judicial activism embodied in the second step of

Maldonado, there may well be a strong inclination fer busi-

ness to incorporate in states more hospitable to them. See,

e.g., Genzer v. Cunningham, 498 F. Supp. 682, 688 (E.D.

Mich. 1980).

Moreover, when one considers that even a meritorious

lawsuit can have a detrimental effect upon a company’s

stockholders due to the significant and rising costs of litiga-

tion, disruption of corporate work force and adverse public-

ity, it becomes piain how wasteful it will become for

ea a

i

*

A- 39

corporations not to believe it worthwhile to move to dismiss

a nonmeritorious case. The Business Round Table, a group

of over one hundred chief executive officers of America’s

largest corporations has publicly stated that a view like the

one adopted by the majority will lead to more derivative

lawsuits being brought, make it more difficult for corpora-

tions to have them dismissed, discourage risk-taking and

make fewer candidates willing to serve on boards of direc-

tors. N.Y. Times, June 10, 1982, at D6. Such real fears

overcome in large measure what the majority implicitly

assumes to be the advantages of limiting directors’ control

over the pursuit of the derivative suit.

Review of Connecticut law lends support to a belief that

something closer to the business judgment rule of Auerbach

is more likely to be adopted by Connecticut’s highest court

than the independent judgment rule of Maldonado. Under

Connecticut law a director is not civilly liable for the conse-

quences of his official actions if in the exercise of his duties

as a director he acts prudently and in good faith. Conn. Gen.

Stat. Ann. §§ 33-313(d),? 33-321(b\2) 33-455(bX2) and 33-

447(d) (West Supp. 1982). See Davenport v. Lines, 77 Conn.

473, 59 A. 603 (1905). Liability has been confined to cases in

which a director has not performed (dereliction of duty),

cases in which a director has used his fiduciary position for

|

2. § 33-313(d) provides in relevant part:

A director shall perform his duties as a director, including his duties

as a member of any committee to the board upon which he may serve, in

good faith, in a manner he reasonably believes to be in the best interests

of the corporation and with such care as an ordinarily prudent person in

a like position would use under similar circumstances. . . A person who

performs his duties in accordance with this subsection shall be presumed

to have no liability by reason of being or having been a director of the

corporation.

Conn. Gen. Stat. An. § 33-131(d) (West Supp. 1982).

Sa an

ss

A-40

personal advantage (breach of a duty of loyalty), and con-

flict of interest cases. S. Cross, Corporation Law in Connect-

icut, at 298 (1972). Business decisions honestly made are

treated as discretionary, even when the interests of stock-

holders are adversely affected. Carter v. Spring Perch Co.,

113 Conn. 636, 155 A. 832 (1931).

Because these statutory standards provide that a director

may avoid liability when he acts in good faith and with

prudent care, they lend support to the rationale underlying

the business judgment rule, i.e., courts should not second-

guess the merits of business decisions honestly and pru-

dently made.

Additionally, independent committees similar to the one

appointed by defendants in this case are recognized and

approved under Connecticut law. See Conn. Gen. Stat. Ann.

§ 33-318(b) (West Supp. 1982). Therefore, I believe the

Supreme Court of Connecticut would refrain from review-

ing the recommendation of independent committees sanc-

tioned under state laws.

IV

My colleagues advance two arguments as to why they

believe Connecticut would not adopt the Auerbach test.

First, they contend that director committees simply cannot

be expected to act independently. Where a special litigation

committee does not act independently and in good faith, its

decision to terminate derivative litigation will not survive

judicial scrutiny under Auerbach. Thus the contention that

director committees will not act independently and in good

faith does not support the conclusion that the Auerbach

standard is inadequate to protect shareholder rights.

Second, the majority argues that limiting judicial review to

the Auerbach test would effectively eliminate the fiduciary

obligations of directors and officers because the sole

method of enforcing these obligations, shareholder deriva-

tive suits, could be eliminated upon the recommendation of

A-41

persons appointed by the officers and directors whose con-

duct is being challenged. Een if shareholder derivative

suits are the only effective method of enforcing the fidu-

ciary obligations of officers and directors, this second objec-

tion to Auerbach again assumes that director committees

reviewing derivative litigation will not act independently

and in good faith. Since Auerbach will require judicial

intervention if the director committees do not so act this

second objection to the use of the Auerbach standard is sim-

ilarly without merit. All this, as well as the majority's dis-

tinction between “demand-excused” cases and

“demand-required” cases, serves only to reveal the true ra-

tionale underlying its opinion — it simply does not believe

that special litigation committees will act independently

and in good faith.

Our Court has been down this path before. When Burks

was before us we took the same position that the majority

now does, i.e., that directors could never be wholly disinter-

ested in deciding whether to pursue claims against fellow

directors. Lasker v. Burks, 567 F.2d 1208, 1212 (2d Cir.

1978). On appeal that view was rejected by the Supreme

Court which concluded that lack of impartiality of disinter-

ested directors is not a determination to be made as a mat-

ter of law. Burks, 441 U.S. at 485 n.15.

Plainly Connecticut’s Supreme Court will be influenced

to some degree by the number of cases that have followed

Auerbach teaching that an unbiased board’s power to ter-

minate derivative litigation is essentially unreviewable.*

*See Gaines +. Haughton, (1981 Transfer Binder] Fed. Sec. L. Rep.

(CCH) 7 98,000 (9th Cir. 1981); H. M. Greenspun v. Del E. Webb Corp..

634 F. 2d 1204 (9th Cir. 1980); Lewis rv. Anderson, 615 F.2d 778 (9th Cir.

1979), cert. denied, 449 U.S. 869 (1980); Abbey v. Control Data Corp.

603 F. 2d 724 (8th Cir. 1979), cert. denied, 444 U.S. 1017 (1980); Joy rv.

North, 519 F.Supp. 1312 (D. Conn. 1981); Abramowitz vr. Posner, 513

F.Supp. 120(S.D.N.Y. 1981), aff'd, 672 F.2d 1025 (2d Cir. 1982); Genzer

„ Cunningham, 498 F.Supp. 682 (E.D. Mich. 1980); Maldonado r.

Flynn, 485 F.Supp. 274 (S. D. N. V. 1980), modified, 671 F.2d 729 (2d

A-42

Applying the Auerbach analysis to the facts in this case,

the district court correctly found that the Committee's

recommendation should be adopted, The committee would

be deemed “independen'” under Connecticut law because

none of the directors had any of the relationships pr hibited

unde Section 33-319 of the Connecticut General Statutes.

For the reasons stated in Judge Eginton’s extensive opinion

below, I believe that the committee acted thoroughly and in

good faith when it recommended termination of the litiga-

tion against some, but not all, of the defendants. Moreover,

a district judge’s interpretation of the law of the state in

which he sits should be accorded substantial deference.

Based upon the foregoing, | would therefore affirm the

grant of summary judgment dismissing the derivative suit

as to the 23 defendants and its continuance as to the others

as recommended by the independent committee.

Cir, 1982); Ronengarten v, International Telephone & Telegraph Corp.

466 F Supp. 817 (8.D.N.Y, 1979); Siegal N Merrick, 84 F. R. D. 106

(8.D.N.Y. 1979); Our own Court eschewed second-guessing by the

courts of what is the responsibility of a corporate board of directors

and, until today, may properly have been included in the above group.

Galef v, Alexander, 616 F.2d 61 (2d Cir, 1980); Abramowits, anpra,

B-1

UNITED STATES DISTRICT COURT,

D. CONNECTICUT,

ATHALIE Doris Joy, PLAINTIFF,

V.

NELSON L. Nortu, et al., DEFENDANTS.

Civ. No, B-77-885.

Aug. 10, 1981.

MEMORANDUM OF DECISION

EGINTON, District Judge.

This shareholder's derivative action was instituted in

1977 on behalf of Citytrust Bancorp., Inc., (then known as

Connecticut Financial Services Corporation), against

numerous officers and directors of Bancorp and its wholly

owned subsidiary Citytrust (collectively, the “Corpora-

tions”). Plaintiff alleges that the defendants violated the

National Banks Act, 12 U.S.C, § 21 et seq., and common law

fiduciary duties, by authorizing and extending a series of

loans for the construction of a building by the Katz

Corporation.

During the pendency of the litigation, the Supreme

Court held in Burka u Lasker, 441 U.S. 471, 99 S.Ct. 1831,

60 L.Ed.2d 404 (1979), that federal courts should as a mat-

ter of federal law, apply state law governing the authority

of independent directors to discontinue derivative suits,

even when the cause of action arises under a federal stat-

ute. The Supreme Court reversed the Second Circuit

Court of Appeals, which had found that as a consequence

of a federal statute disinterested directors did not have the

power to foreclose the continuation of nonfrivolous litiga-

tion brought by shareholders against majority directors

for breach of their fiduciary duties. /d. at 475, 99 8.Ct. at

1835, The Supreme Court rejected that the existence of

federal question jurisdiction rendered state law irrelevant,

wedi Pied Whe

iS

Wye

j 0

particularly in the area of corporate law. To the contrary,

the Burks decision emphasized the importance of state cor-

poration law, “which is the font of corporate directors’

powers,” as distinct from federal law in this area, which is

“largely regulatory and prohibitory in nature—it often

limits the exercise of directorial power, but only rarely

creates it.” Jd. at 478, 99 S.Ct. at 1837.

I Based on the Burks decision, a federal court con-

fronted with a recommendation by a disinterested panel of

directors to dismiss a derivative action must as a threshold

matter determine whether state law permits such a dismis-

sal and under what circumstances. If so, the next inquiry

mandated by Burks is whether the state rule is consistent

with the policy of the federal statute upon which the deriva-

tive suit is based. Finally, even if state and federal law

permit an independent committee to initiate a business

judgment dismissal, then the federal court must assure

itself of the integrity of the committee by reviewing the

independence, good faith and thoroughness of the decision.

If all three prongs of the Burks test have been satisfied,

then the committee’s recommendation will be upheld.

Immediately following the Supreme Court's decision in

Burks, the Board of Directors of the Corporations in the

instant case authorized the establishment of the Special

Litigation Committee (hereinafter the Committee“), to

determine whether the continued prosecution of the deriva-

tive suit would serve the best interests of the Corporations,

In appointing the Committee, the directors relied on Burks

and its progeny, and selected two directors, Ms. Marion 8.

Kellogg and Mr. Ernest C. Trefz, claimed to be indepen-

dent and disinterested in the derivative litigation.' The

Committee thereafter retained the law firm of Murtha,

Cullina, Richter and Pinney to assist in conducting the

I. The Committee's third original member, Alexander IL. Stott,

resigned on March 3, 1980.

B-3

investigation. By resolution dated August 15, 1979, the full

board delegated to the Committee the power to review,

investigate and analyze the circumstances surrounding the

pending derivative action. Nine months later, counsel to the

Committee submitted a three-volume report, which con-

tained the unanimous recommendation that the suit be dis-

missed against twenty-three designated defendants, but

continued or settled as to the remaining seven defendants.’

When plaintiff failed to voluntarily withdraw the claims

against the defendants in accordance with the Committee’s

determination, the Corporations filed motions, first to dis-

miss and thereafter for summary judgment. This Court

repeatedly denied the motions, without prejudice and sub-

ject to renewal, to enable plaintiff to conduct limited discov-

ery into the “good faith, motivation and thoroughness” of

the Committee's investigation. At the conclusion of the stip-

ulated discovery schedule, the Corporations renewed their

motion for summary judgment on the grounds that the bus-

iness judgment rule was available under state law and had

been properly invoked to terminate the derivative suit.

Plaintiff, in opposing the motion, contends that even if Con-

necticut recognizes the business judgment rule (which she

vigorously disputes), the Corporations may not foreclose

prosecution of claims involving alleged fraud and breach of

trust. In addition to a full scale attack on the business judg-

ment rule and the concept of a special litig tion committee,

plaintiff also challenges every phase of the Committee’s

investigation, from the procedures employed in its forma-

tion to the ultimate substantive conclusions.

2. Of the twenty-three who seek dismissal, twenty include outside

directors of either Citytrust or the Bancorp, while the remaining three

are either officers or directors of the Corporations.

B-4

I

BUSINESS JUDGMENT RULE

2. 3] The power of a corporation to manage daily inter-

nal affairs without interference by the courts has long been

recognized. The so-called business judgment rule is based

on the premise that directors of a corporation have the req-

uisite expertise to resolve the daily business matters which

form an integral part of corporate life, an expertise that

cannot be matched by courts or shareholders. So long as

directors render an unbiased judgment in carrying out

their responsibilities, they will not be held liable for honest

errors. Nor will the board’s decisions be subject to review

by outside interests, absent proof of bad faith or prejudice.

Galef u Alexander, 615 F.2d 51, 57 (2d Cir. 1980), citing 3A

Fletcher, Cyclopedia of the Law of Private Corporations, §

1039 (perm. ed. 1975).

[4] Since 1917, the Supreme Court has recognized the

power of directors to invoke the business judgment rule to

determine whether or not to enforce in the courts claims

available to the corporation. In United Copper Securities

Co. v. Amalgamated Copper Co., 244 U.S. 261, 263-64, 37

S. Ct. 509, 510-11, 61 L.Ed. 1119 (1917), the Supreme Court

held:

Whether or not a corporation shall seek to enforce in the

courts a cause of action for damages, is, like other busi-

ness questions ordinarily a matter of internal man

ment, and is left to the discretion of the directors, in the

absence of instruction by vote of the stockholders.

Courts interfere seldom to control such discretion intra

vires the corporation, except where the directors are

guilty of misconduct equivalent to a breach of trust, or

where they stand in a dual relation which prevents an

unprejudiced exercise of judgment.

This analysis by the Supreme Court dealing with the initia-

tion of a derivative action has been not only followed but

expanded. In its most recent decision involving a derivative

suit, Burks v. Lasker, supra, 441 U.S. 471, 99 S.Ct. 1831, 60

B-5

L.Ed.2d 404 (1979), the Supreme Court noted that it is only

consistent with such reasoning to extend directors’ discre-

tionary power to include decisions to terminate an ongoing

derivative suit. /d. at 485, 99 S.Ct. at 1840. Whether in a

given case a committee of disinterested directors may rely

upon the business judgment rule to terminate a suit found

to be detrimental to the interests of a corporation depends

on the particular state law governing the status and scope

of that rule. Id. at 480, 99 S.Ct. at 1838.

1

STATE LAW

Accordingly, the Court's first inquiry under Burks

relates to the status of the business judgment rule under

applicable state law. In this case, where both Bancorp and

Citytrust are incorporated in Connecticut, it must be deter-

mined whether Connecticut's corporation law embraces the

rule, and if so, whether the scope is sufficient to encompass

a decision by an independent committee to terminate a

pending derivative suit. Absent any direct statutory or judi-

cial authority for guidance, this Court finds support for the

rule in sources including, but not limited to. state court

opinions, state statutory scheme, specific statutory provi-

sions, concepts of modern corporate law, and by analogy to

other state law schemes.

Connecticut courts have long consistently observed the

basic tenet of corporation law that the discretion to manage

the daily affairs of a corporation rests with its directors.

See, e.g. Osborne v. Locke Steel Chain Co., 153 Conn. 527,

218 A.2d 526 (1966). That discretion, however, is not with-

out its limits. In the earliest Connecticut decision setting

forth the doctrine, Pratt v. Pratt, Read & Co., 33 Conn. 446

(1866), the Supreme Court dealt with a request for injunc-

tive relief brought by a group of stockholders seeking to

prevent a corporation from devoting surplus funds to the

erection of a new building, and to compel distribution of

B-

those funds to the stockholders. The court noted that the

directors acted without malice, improper motive or fraud.

and exercised sound and reasonable judgment and discre-

tion. Id. at 451. In refusing to interfere with the directors’

proposal, the court nevertheless noted that it would not hes-

itate to intervene through its equity powers based on a

showing that the directors had exceeded their powers as

bestowed by the corporate charter. Id. at 455.

The parameters set forth in Pratt have been followed in

the Connecticut decisions of this century. See, e.g. Van Tas-

sel v. Spring Perch Co,, 118 Conn. 636, 646-47, 155 A. 832

(1931); Carten v. Carten, 153 Conn. 603, 615, 219 A.2d 711

(1966). These decisions wherein the state court has

refrained from second-guessing directors’ good faith deci-

sions concerning the corporation’s best interests represent

an implicit acceptance of the business judgment doctrine in

Connecticut, with the limitation that not all decisions are

insulated from judicial scrutiny on a blanket basis.

[5] This Court’s finding that the business judgment rule

exists as a matter of law in Connecticut is not supported

merely by the cases just cited, but finds support also in a

review of the state’s corporate law scheme and its legisla-

tive history. Although no single provision of Connecticut

law expressly refers to the business judgment rule, it is

derived from the power of the board of directors to manage

the corporation, pursuant to C.G.S. § 33-313(a), which

states:

Subject to any provisions pertaining thereto contained

in the certificate of incorporation, the business, prop-

erty and affairs of a corporation shall be managed by or

under the direction of its board of directors.

In interpreting a state law provision analogous to this Con-

necticut statute which invests directors with the power to

manage the corporation, the Delaware Supreme Court

explained:

B-7

ba: ead ms vaed fount of directorial powers. The ‘busi-

1 certain circumstances, in a board’s

vam defensively, it does not create author-

It is ly used as a defense to an attack on

the he decision’ soundness. The board’s managerial deci-

pec i ee er, however, comes from [the statute].

The judic — 4. and * grant are rela

because the business judgment' rule evolved to ae

recognition and deference to directors’ business ex

ee 1 exercising their managerial power under the

Zapata Corp. v. Maldonado, 430 A.2d 779, at 782 (Del. Sup.

1981), rev'’g Maldonado v. Flynn, 413 A.2d 1251 (Del. Ch.

1980). Although the Connecticut Supreme Court has not as

yet so specifically equated the managing power statute to

the existence of a Connecticut business judgment rule, the

cases leave no doubt that the rule is a judicial creation, the

source of which is found in the legislative grant of authority

conferred upon corporate directors by C.G.S. § 33-313(a).

Further support for the existence of the business judg-

ment rule in Connecticut is found in the legislative history

of the state’s corporate law scheme. One commentator has

examined the evolution of corporate law‘ Connecticut and

concluded that the comprehensive revision of the statutes in

1959 to conform to the ALI—ABA Model Business Corpo-

ration Act, “brought Connecticut’s corporation law into line

with, and in some respects well ahead of, the modern

trend.” S. Cross, Corporate Law in Connecticut 38 (1972).

Amendments subsequently enacted by the legislature

which correlate with changes in the Model Act reflect a

continual expansion of the discretionary powers available

to directors. The legislative history of one such amendment

confirms that the supporters of the proposed addition to

C.G.S. § 33-313(d) specifically intended to incorporate the

business judgment rule. As one Senator explained:

B-8

The Bill changes the t duty of care ining to

Directors of ions from the duly diligent exer-

cise of the duties of his office to the business judgment

rule as has been expressed by the Courts.

Senate Reports, Vol. 18, part 3, p. 1418 (May 1, 1975). The

constant revision of Connecticut statutes in this area evin-

ces an intention by the legislature to adopt as part of the

state’s corporation law a broad range of powers associated

with the business judgment rule.

[6] Having thus found that the business judgment rule

exists on a broad basis as a matter of Connecticut law, this

Court must determine whether the scope of the doctrine is

sufficient to encompass a decision by disinterested direc-

tors to dismiss a pending derivative suit. This exact ques-

tion has never been addressed by a Connecticut court, nor

for that matter has a Connecticut court ever addressed the

question of the discretionary power of a corporation to

initiate and maintain a derivative action. Nonetheless, both

of these issues are relevant since, as previously noted, the

Supreme Court has held that the power to discontinue an

action is a logical extension of the power to institute the

action. Burks, supra, 441 U.S. at 485, 99 S.Ct. at 1840.

In predicting how a state court would rule if presented

with this precise question, this Court finds sparse guidance

in the previously cited judicial decisions using the business

judgment rationale in unrelated contexts, even though the

language of the opinions was expansive. This Court primar-

ily relies on the extensive weight of judicial authority in

other jurisdictions, wherein courts have found that when

state law embraces the business judgment rule, its scope

includes a decision by a disinterested and independent com-

mittee of directors to terminate a derivative suit, subject to

limited review of the committee’s good faith and integrity.’

3. See, e. g. Gaines v. Haughton, 645 F. 2d 761 (C.A.9), 1981; Clark v.

Lomas & Nettleton Financial Corp., 625 F.2d 49 (5th Cir. 1980), cert.

denied. U.S. . 101 S.Ct. 1738, 68 L.Ed.2d 224 (1981); Lewis u.

ea

5494

B- 9

PLAINTIFF'S INTERPRETATION

OF STATE LAW

Notwithstanding the ample percent permitting directors

to use a state business judgment rule as authority to termi-

nate an ongoing derivative suit, plaintiff contends that

when the action is based on breach of trust or other fidu-

ciary wrongs, Connecticut law requires a different result.

To support her position, plaintiff relies on specific statutory

provisions and corporate law concepts which are generally

applicable to decisions rendered by directors. Once again,

no Connecticut court has addressed whether the authority

upon which plaintiff relies is relevant in the particular con-

text of a business judgment dismissal of a derivative suit.

However, derivative plaintiffs in other jurisdictions have

unsuccessfully presented arguments similar to the four

made by the instant plaintiff. Those courts confronted with

challenges based on analogous laws and concepts have

rejected such authority as inapplicable to the specific issues

raised when an independent committee votes to terminate a

pending derivative suit.

Anderson, 615 F.2d 778 (9th Cir. 1979), cert. denied, 449 U.S. 869, 101

S.Ct. 206, 66 L.Ed.2d 89 (1980); Galef v. Alexander, 615 F.2d 51 (2d Cir.

1980); Abbey v. Control Data Corp., 608 F.2d 724 (8th Cir. 1979), cert.

denied, 444 U.S. 1017, 100 S.Ct. 670, 62 L.Ed.2d 647 (1980); Cramer v.

GE Corp., 582 F.2d 259 (3d Cir. 1978), cert. denied, 439 U.S. 1129, 99

S.Ct. 1048, 59 L.Ed.2d 90 (1979); Abramowitz v. Posner, 513 F.Supp. 120

(S.D.N.Y.1981); Maldonado , Flynn, 485 F.Supp. 274 (S.D.N.Y.1980),

appeal docketed, No. 80-7221 (2d Cir. 1980); Rosengarten v. Interna-

tional Tel. & Tel. Corp., 466 F. Supp. 817 (S.D.N.Y.1979); Zapata Corp.

„ Maldonado, 430 A.2d 779 (Del.Sup.1981), rev'd, Maldonado v. Flynn,

413 A.2d 1251 (Del.Ch.1980); Lewis v. Adams, Civ. No. 77-266C

(N.D.Okla. 11/15/79); Genzer v. Cunningham, 498 F.Supp. 682

(E.D.Mich.1980); Gall v. Exxon Corp., 418 F. Supp. 508 (S.D.N.Y.1976);

Auerbach u. Bennett, 47 N.Y.2d 619, 419 N. V. S. 2d 920, 393 N.E.2d 994

(1979).

e

B- 10

7, 8] First, plaintiff denies that directors charged with

common law breach of trust have power to terminate a suit

against themselves. This argument might have merit if the

defendants actually charged with violation of trust sought

on their own to dismiss the action. Indeed, the Supreme

Court has held that directors guilty of misconduct equiva-

lent to breach of trust lack the power under certain circum-

stances to exercise their business judgment. United Copper

Securities Co., supra, 244 U.S. at 264, 87 S.Ct. at 510. How-

ever, once an independent committee has been appointed,

the fate of the derivative suit is no longer in the hands of the

defendant directors charged with wrongdoing, but rather

is under the exclusive control of a disinterested committee.

The focus thus shifts from those accused of breach of trust

over to the committee members. So long as the committee

consists of directors who are not personally responsible for

the breach of trust, or otherwise involved in the alleged

illegality, they have the power, properly exercised, to

absolve those directors claimed to have breached their fidu-

ciary duties.

[9] Second, plaintiff contends that the right conferred on

a shareholder to initiate a lawsuit under the state deriva-

tive suit statute, C.G.S. § 52-572j, necessarily confers an

absolute right to maintain the action undisturbed by direc-

tors in the exercise of their business judgment. Virtually

every court faced with this claim has categorically rejected

that the right to bring a derivative suit supports an unres-

tricted right to continue to control it. As the Ninth Circuit

held in Lewis v. Anderson, 615 F.2d 778, 783 (9th Cir. 1979),

cert. denied, 449 U.S. 869, 101 S.Ct. 206, 66 L.Ed.2d 89

(1980):

To allow one shareholder to incapacitate an entire

board of directors merely by leveling charges inst

them gives too much leverage to dissident shareholders.

ala

B-11

More recently, the Delaware Supreme Court elaborated

upon this distinction in Zapata v. Maldonado, supra, at

784-785:

We see no inherent reason why the ‘two phases’ of a

derivative suit, the stockholder’s suit to compel the cor-

poration to sue and the corporation's suit should auto-

matically result in the placement in the hands of the

litigating stockholder sole control of the corporate right

throughout the litigation. To the contrary, it seems to us

that such an inflexible rule would recognize the interest

of one —_ or group to the exclusion of all others

within the corporate entity.

This Court agrees that placing continuous control of the

corporate cause of action in the exclusive hands of the lit-

igating shareholder would elevate the interests of an iso-

lated group over those of the corporate entity, in a manner

neither contemplated by the legislature in enacting the

derivative suit statute nor evident in the legislative history.

Even a cursory glance at the derivative suit statute,‘

reveals that the legislature intended to set up a mechanism

to formalize a shareholder’s power to bring derivative

actions on behalf of the corporation. The legislature specifi-

cally included limits on a shareholder’s power by providing

4, Whenever any corporation or any unincorporated association fails

to enforce a right which may properly be asserted by it, a derivative

action may be brought by one or more shareholders or members to

enforce such right, provided such shareholder or member was a share-

holder or member at the time of the transaction of which he complained

or his membership devolved on him by operation of law. Such action

shall be begun by a complaint returnable to the superior court for the

county or judicial district in which an office of the corporation or associ-

ation is located. The derivative action may not be maintained if it

appears that the plaintiff does not fairly and adequately represent the

interests of the shareholders or members similarly situated in enforcing

the right of the corporation or association. The action shall not be dis-

missed or compromised without the approval of the court, and notice of

the proposed dismissal or compromise shall be given to shareholders or

members in such manner as the court directs.

— ae

=)

2

3-12

that under certain eireumstances, a court had the power to

approve disrnissal or compromise of a derivative action,

even after it had commenced. That power defeats plaintiff's

claim that the statute creates a substantive, indefeasible

right in a shareholder to litigate a derivative suit to its

conclusion without interference. Moreover, this Court finds

no indication that the legislature intended by the derivative

suit statute to grant a shareholder unbridled discretion to

proceed with a suit in the face of opposition by an indepen-

dent committee which has found the suit detrimental to the

corporation. This Court accordingly finds no substance in

plaintiff's reliance on C. G. S. § 52-572) as the source of any

absolute right to prosecute the instant suit to verdict.

Plaintiff's third ground for opposing dismissal is based

on the alleged inapplicability of the business judgment rule

to “non-ratifiable” wrongs. Plaintiff cites numerous deci-

sions in other jurisdictions which hold that neither the

board of directors nor a majority of shareholders may by

ratification validate a wrong which the corporation itself

lacks the power to remedy. According to plaintiff's analy-

sis, by seeking to dismiss claims relating to the alleged

wrongful extension of certain loans, the directors are

impermissibly attempting to ratify the original (non-

ratifiable) conduct. The flaw in tlus argument was noted by

a district court in Laseſ inirks, 404 F.Supp. 1172, 1180

(S.D.N.Y.1975), rev'd on other grounds, 441 U.S. 471, 99

S.Ct. 1831, 60 L.Ed.2d 404 (1979):

The court must also reiect plaintiffs’ argument that the

decision not to sue was tantamount to an illegal ratifica-

tion. Although it can be argued that derivative suits

should be allowed when the Board has refused to sue on

a non-ratifiable wrong, the question of business dra,

ment is separate from the question of ratification, Many

of the cases which established the business judgment

rule and its relation to derivative suits have involved

claims which were arguably non-ratifiable.

B-13

Accord, Gall v. Exxon, 418 F.Supp. 508, 518 n. 18

(S.D.N.Y.1976).

10] To ratify a corporate act involves a limited decision

by the directors as to the propriety of certain actions under-

taken by those charged with managing the corporation.

The directors’ concern in a ratification context is therefore

primarily whether the underlying conduct being reviewed

is legal. If it is concluded that the conduct may expose the

corporation to liability, then such wrongful activity may

not be ratified. In contrast to a ratification situation, the

exercise of business judgment in the context of a derivative

suit involves a broader focus, wherein the legality of the

underlying claims is only one of numerous factors consid-

ered by the board, including but not limited to ethical, com-

mercial, promotional, public relations and fiscal concerns.

Auerbach v. Bennett, 47 N.Y.2d 619, 419 N.Y.S.2d 920, 928,

898 N.E.2d 994, 1002 (1979). Whether the conduct is

regarded as legal or not, the directors’ pa amount concern

is whether the prosecution of the suit wili harm or benefit

the corporation. If, after reviewing the impact on the corpo-

ration, the directors determine that the Jitigation should be

disposed of, “the conclusive effect of such a judgment can-

not be affected by the alleged illegai nature of the initial

action which purportedly gives rise to the cause of action.”

Gall v. Exxon, supra, 418 F.Supp. at 518; accord, Rosen-

garten v. ITT, 466 F.Supp. 817, 824 (S.D.N.Y.1979).

[11] Directors possess the power to terminate an action

which may be meritorious from a legal standpoint, despite

objection of shareholders or the public, because a derivative

suit is unique. As a mechanism for correcting corporate

wrongs as opposed to public wrongs, a derivative suit con-

cerns rights belonging exclusively to the corporation, and

any judgment inures to the sole benefit of the corporation.

Therefore, whatever interest a shareholder or the public

may have in rectifying unlawful conduct must yield to the

business judgment of directors who have in good faith con-

B-14

cluded that the corporation ultimately gains rather than

loses rights by discontinuing the action.

This does not mean, however, that directors may engage

in illegal activity with impunity, relying on the prospect

that a disinterested committee will seek dismissal on their

behalf. To the contrary, when unlawful acts have been com-

mitted, there are other mechanisms available to the public

or shareholders to enforce any rights infringed as a result

of illegal corporate activities. The government may either

prosecute alleged wrongdoers, which serves the public

interest by punishing illegal conduct, or a shareholder may

bring a direct action, which enables those personally

harmed by the conduct to seek redress. These suits are not

subject to dismissal at the instance of directors. As such,

they provide adequate safeguards against directors who

attempt to ratify conduct not capable of ratification. There-

fore, plaintiffs reliance on the allegedly non-ratifiable

nature of the defendants’ conduct in the instant case is mis-

placed in the context of this derivative suit.

12 Finally, plaintiff contends that from the Commit-

too formation through the consequent motions to dismiss

the suit against the corporation's own directors, there exists

a successive chain of self-dealing transactions outside the

scope of the business judgment rule. For this proposition,

plaintiff relies on C.G.S. § 33-828, pertaining to the void-

ability of transactions between interested directors and the

corporation, According to plaintiff, the fact that thirteen

out of a total sixteen directors who appointed the Commit-

tee were also named as defendants automatically taints

both phases of the Committee process—the formation stage

and the final determination. She contends that by allowing

interested directors to participate in the vote appointing

the Committee, the Corporation insured the selection solely

of members certain to recommend dismissal. Based on this

premise, plaintiff concludes that an independent Commit-

tee, free of self-dealing, is structurally impossible so long as

the members owe their appointment to interested directors.

B-15

With respect to plaintiff's claims of self-dealing in the

formation phase, other courts faced with analogous argu-

ments have conceded the potential for self-dealing or struc-

tural bias“ in the establishment of a special committee. Asa

New York court noted in Auerbach, supra:

The ible risk of hesitancy on the part of the

mem of any committee . . to investigate the activi-

ties of fellow members of the board where personal lia-

bility is at stake is an inherent, inescapable, given

aspect of the pres redicament, 419 N. V. S. 2d

at 928, 393 N. E. 2d at 1002

This “predicament” exists in the nature of the corporate

organization, wherein only the existing board of directors

has authority under state law to establish a special commit-

tee and to delegate the power to act on behalf of the entire

board. Notwithstanding the potential for bias, the same

court held that:

To assign responsibility of the dimension here involved

to individuals wholly separate and apart from the board

of directors would, except in the most extraordinary

circumstances, itself be an act of default and breach of

the nondelegable fiduciary duty owed by the members

ot te to the corporation and to its shareholders.

No decision which plaintiff has cited to this Court has held

that this unique relationship between defendant directors

and the directors they chose to determine the fate of the

derivative suit is grounds, standing alone, either to dissolve

the Committee or invalidate its results. In fact, to take this

position would compel this Court to find self-dealing by the

directors even though they followed procedures prescribed

by statute and corporate bylaws in appointing an indepen-

dent Committee. Moreover, to find these procedures infirm

5. Structural bias is inherent prejudice against all derivative suits by

virtue of the composition of the board and relationship between direc:

tors, whereas actual bias resulta from a particular director's personal

involvement in the specific transactions underlying the suit.

B-16

and voidable under the statute would place in jeopardy the

concept of a litigation committee at a time when such com-

mittees have become widely accepted, useful tools for dis-

posing of detrimental derivative actions.

As to plaintiff's claims of bias during the Committee's

deliberative stage, she accuses the Committee members of

continued acts of self-dealing by virtue of their frequent

contact with interested directors at board meetings and

other functions throughout the period of the investigation.

It is this ongoing relationship between the directors on the

Committee and the director defendants which plaintiff

claims is fatal to the Committees power to render a busi-

ness judgment dismissal, This is because, according to

plaintiff, these affiliations rendered the decision to dismiss

a foregone conclusion. If this Court accepted plaintiff's

“conspiracy” argument, it would be compelled to declare

the Committee's final recommendation to be a voidable self-

dealing transaction, pursuant to C.G.S. § 33-323, In the

absence of state judicial or statutory authority applying the

self-dealing statute in this context, this Court must predict

whether a state court would find that all interaction

between defendant directors and non-defendant Committee

members rises to the level of a self-dealing transaction suf-

ficient to nullify the Committee's exercise of its business

judgment.

This Court has examined the self-dealing statute, as the

state court would do, and conc\udes that the legislature

enacted C. G. S. § 33-323 to prohibit directors from reaping

personal financial gain at the corporation’s expense by

exploiting their insider status. Under the terms of the stat-

ute, any transaction which results from a director's abuse

of his fiduciary position is rendered voidable at the option of

the entire board. There is no authority for plaintiff's expan-

sive interpretation of the self-dealing statute as compelling

the invalidation of the Committee's final decision merely

because its members continued to interact with the director

B-17

defendants. Absent such authority, this Court declines to

construe the statute so broadly, particularly when plaintiff

has not uced any evidence of actual self-dealing, as

distinct mere speculation. Only proof of actual self-

dealing during either the formation or deliberative phase

of the Committee’s investigation would warrant a finding

that the entire process must be voided.

[13] Having thus rejected the last of four grounds which

plaintiff raised as state statutory impediments to the appli-

cation of the business judgment rule in the context of a

derivative suit dismissal, this Court finds no remaining

barrier under state law to the Committee's exercise of its

judgment in the instant case.

ia ot hie

9 —

B-18

IV

FEDERAL LAW

14] Once having found that a Connecticut business judg-

ment rule exists and that it permits an independent com-

mittee to seek dismissal, this Court must determine

whether approval of the Committee’s recommendation

would conflict with federal law. Burks v. Lasker, supra, 441

US. at 480, 99 S8. Ct. at 1838. When a derivative suit rests in

whole or in part on a federal law, in this case the National

Banks Act, such law does not render state law irrelevant.

To the contrary, the indisputable mandate of Burks is that

unless federal law directly conflicts with the state scheme

or unless application of state law “would be inconsistent

with the federal policy underlying the cause of action,”

state law prevails. Id. at 479, 99 S.Ct. at 1837, citing John-

son v. Railway Express Agency, 421 U.S. 454, 465, 95 S.Ct.

1716, 1722, 44 L.Ed.2d 295 (1975). This mandate remains

true even if the application of state law would cause a deriv-

ative plaintiff to lose litigation based on meritorious federal

claims. /bid. In fact, the Supreme Court held that federal

law would preempt relevant state law only if Congress spe-

cifically intended federal law to replace the entire corpus of

state corporate law. Id. at 478, 99 S.Ct. at 1837. Congress

will evince such an intention either by enacting a compre-

hensive federal scheme which permits of no state variation,

or by including an express statutory provision which pre-

vents the corporation from invoking its state powers. Id. at

479, 484, 99 S.Ct. at 1837, 1840. Absent an unequivocal

message from Congress that federal law supplies the exclu-

sive rule of decision, or that compelling federal interests

override powers conferred by state law, state corporate law

must control.

[15] In the context of the instant derivative suit, so long

as the National Banks Act is not found by this Court to be

Pi

B-19

inconsistent with state law, the Connecticut business judg-

ment rule will dictate whether the Committee may termi-

nate the action. Plaintiff contends that both the letter and

the spirit of the National Banks Act, 12 U.S.C. § 21 et seq.

(hereinafter, the Act“), conflict with the Committee's

power to compel dismissal. She relies on four sections of the

Act to support claims of inconsistency between state and

federal law: Sections 24 (corporate powers of associations);

§ 73 (violation of oath of office by directors); § 84 (overline

loan); § 93 (director liability for violation of the Act). After

listing these provisions, plaintiff concludes, without analy-

sis, that permitting the directors to dismiss would be con-

trary to and frustrate the purposes of the Act. This Court

finds these conclusory remarks insufficient to satisfy

Burks, which requires a federal court to carefully review

the federal law before rendering a decision as to the degree

of conflict or consistency between state and federal law.

This Court has conducted such a review, and for the follow-

ing reasons rejects plaintiffs claims of inconsistency.

In support of plaintiff's claim based on § 84, pertaining to

overline loans, she contends that the Committee concluded

in its report that the directors might be liable for an over-

line violation with respect to the Katz loans. Based on that

alleged finding, plaintiff claims that termination of the suit

would conflict with this provision of the Act. However,

after reviewing the Committee’s report, this Court has

found no such admission of liability contained therein.

Rather, the figure discusssed in the report merely reflects

the Committee’s valuation of the magnitude of the loans. In

fact, the Committee expressed serious doubt in its report as

to whether liability could be found based on the uncertainty

of damages suffered by the corporation. Plaintiff has there-

fore misinterpreted the Committee’s conclusion regarding

the Katz loans.

[16] Even assuming arguendo that the directors had

authorized an overline loan and plaintiff could prove that

\ ch ded

B-20

such loans violated federal law, Burks makes it plain that

simply by enacting a federal law, Congress did not require

that states, or federal courts, absolutely forbid director ter-

mination of all nonfrivolous actions. Burks, supra, 441 U.S.

at 486, 99 S.Ct. at 1841. The proper inquiry is therefore not

whether the federal claims of overline loans have merit, but

whether any single provision of the federal statute, such as

§ 84, specifically prohibits dismissal in accordance with the

state’s business judgment rule. This court finds no indica-

tion that Congress intended § 84 of the Act to prevent board

action from cutting off detrimental derivative suits.

[17] With respect to claims of conflict based on Section

24, relating to corporate powers of associations, plaintiff

has offered only conclusory statements that applying state

law would pose Aa] significant threat to any identifiable

federal policy or interest.” Burks, supra, 441 U.S. at 479, 99

S.Ct. at 1838. This section simply sets forth the general

corporate powers of associations. It does not provide that

the powers therein are meant to preempt state law. Yet by

relying on this provision of the Act, plaintiff attempts to

persuade this Court that the mere existence of a broad fed-

eral statute requires that state laws governing corporate

affairs be displaced. This position has been rejected by the

Supreme Court in Burks;

Corporations are creatures of state law, and it is state

law which is the font of corporate directors’ powers. By

contrast, federal law in this area is largely regulatory

and prohibitory in nature — it often limits the exercise

of directorial power, but only rarely creates it . . Con-

gress has never indicated that the entire corpus of state

corporation law is to be replaced * because a

plaintiff's cause of action is based upon a federal statute.

441 U.S. at 478, 99 S.Ct. at 1837.

The National Banks Act belongs in this category of laws

which are primarily regulatory. As the Supreme Court

held in Anderson National Bank v. Luckett, 321 U.S. 233,

248, 64 S.Ct. 599, 607, 88 L.Ed. 692 (1943), notwithstanding

B-21

that national banks derive their powers from the federal

statute, they remain subject to the laws of the state. This

Court therefore finds no basis to plaintiff's claim of conflict

between § 24 and state law in the case at bar.

Plaintiff also relies on Section 73 of the Act to support a

possible conflict between state and federal law. That provi-

sion requires each director to take an oath that he will dili-

gently and honorably administer the corporation’s affairs.

State law imposes the identical obligation on all directors

as fiduciaries, to conduct the business of the corporation in

an honest and unprejudiced manner; the two bodies of law

coincide rather than conflict. Plaintiff's claims of inconsis-

tency between federal and state law under Section 73 of the

Act is therefore without basis.

Finally, Section 93 provides that in the event of a judicial

determination of liability in a suit filed by the Comptroller

of Currency, a director responsible for violating the statute

may be exposed to liability. Plaintiff contends that in the

absence of any express language in the federal statute au-

thorizing an independent committee to invoke the state bus-

iness judgment rule in the face of such a finding of liability,

no such power exists. It is the statute’s silence with respect

to derivative suits and business judgment dismissals which

plaintiff claims precludes the Committee from terminating

the suit under state law. Confronted with a similar argu-

ment under the Investment Advisors and Investment Com-

pany Acts in Burks, the Supreme Court found that “such

silence was to be expected.” 441 U.S. at 478, 99 S.Ct. at

1837. This is because federal laws relating to corporate gov-

ernance do not purport to be a positive source of authority

for managerial power, but rather function primarily to

impose controls and restrictions on leadership. /bid. For

this reason, it is not surprising that neither the National

Banks Act nor any other federal statute discussed by the

Supreme Court in Burks contain direct language referring

to the business judgment rule. The Supreme Court did not

9 e

2 E

i

B-22

regard the absence of a formal reference as an impediment

to invoking the state business judgment rule. Instead, the

Supreme Court fashioned a different test which does not

depend on whether the rule literally appears in the federal

statute, but whether the state business judgment rule con-

flicts with a federal law or policy. Jd. at 479, 99 S.Ct. at

1837. :

Admittedly, where a provision such as § 93 of the Act

imposes a penalty for a wilful violation, it appears inconsist-

ent with the spirit, if not the letter, of the law to permit

state law to prevent federal wrongs from being redressed

in the courts. Notwithstending, courts have repeatedly

allowed committees properly constituted under state law to

dismiss derivative suits based on nonfrivolous and possibly

illegal conduct, so long as the federal law contained no pro-

vision expressly forbidding directors from terminating the

suit. Burks, supra, 441 U.S. at 484, 99 S.Ct. at 1840; Gall v.

Exxon, supra, 418 F.Supp. at 518; Rosengarten v. ITT,

supra, 466 F.Supp. at 824. Plaintiffs claims to the con-

trary, this Court finds no suggestion of a Congressional pur-

pose in § 93 of the Act, or any of its other provisions, to

interfere with a business judgment decision made in accor-

dance with state law to discontinue a derivative suit based

in part on the National Banks Act.

Finally, there are two features of the instant case which

further illustrate that deference to state law would not con-

flict with federal law. First, the Committee did not recom-

mend dismissal of the entire suit. Rather, it invoked the

business judgment rule to terminate only as to those defend-

ants who were not officers at the bank at the time of the

extension of the allegedly improper loans. In other words,

by allowing plaintiff to proceed with the suit against seven

individuals claimed to have been directly responsible for

violating federal law, the Committee used state law to effec-

tuate, rather than to defeat, the purposes of federal law.

Ae hee

phases 4

B-23

Second, even if the Act embodies an “identifiable federal

policy or interest”, Burks, supra, 441 U.S. at 479, 99 S.Ct. at

1838, such policy would not be contravened by allowing

dismissal of the instant derivative suit against a bank no

longer subject to national regulation. Nearly a year before

the suit commenced, Citytrust altered its status from a

national to a state bank. Subsequent to that time, the bank

has been regulated entirely by state mechanisms without

interference by federal banking agencies. Thus, the signifi-

cance of federal interests with respect to this action is de

minimis. Finding no conflict or inconsistency between the

National Banks Act and the state business judgment rule,

this Court holds that the second prong of the Burks test has

been satisfied.

B-24

V

BONA FIDES

{18} Having completed the first two inquiries under the

Burks analysis, this Court must finally determine whether

the Committee satisfied the requirements of independence,

good faith, and thoroughness. Review is limited to these

aspects of the Committee’s investigation and does not

involve an assessment of the merits of the derivative suit.“

To probe the merits would defeat the purpose of the busi-

ness judgment rule, which is premised on the expertise of

directors to render important business decisions without

interference by the courts or shareholders. Although courts

may be ill-equipped to evaluate whether a particular deriv-

ative suit serves a corporation’s best interests, they are

well-suited to determine the bona fides of an independent

committee’s investigation. If, following review, a court

finds the investigation to have been incomplete or pro

forma, a rejection of the committee's decision would be jus-

tified. In so scrutinizing the investigative techniques, a

court must be cautious not to trespass on the committee’s

business judgment, or to grant summary judgment unless

satisfied that no genuine issue of material fact exists as to

its disinterest and integrity. Auerbach v. Bennett, supra,

419 N.Y.S.2d at 929, 393 N.E.2d at 1002.

After this Court authorized plaintiff to conduct limited

discovery into the Committee’s good faith, the parties

exchanged an extensive amount of materials. Although

n'aintiff submitted requests for production beyond the

scope of this Court’s order, the Committee complied with

6. This Court has maintained this position throughout, by limiting

plaintiff on three occasions to discovery as to the good faith, motivation

and thoroughness of the Committee's investigation. See, e.g. Rosen-

garten v. ITT, supra, 466 F.Supp. 817, 823. Despite these restrictions,

plaintiff has continued to address the merits of the underlying action.

B- 25

the majority of requests without objection.’ Notwithstand-

ing the release of voluminous information during this addi-

tional period of discovery, plaintiff devoted only two pages

of a lengthy brief to assailing the independence and motiva-

tion behind the Committee’s investigation. Contained in

plaintiff's brief are four areas which she claims bear on the

integrity of the investigation. Of those claims, plaintiff has

not provided this Court with proof of actual bias sufficient

to remove the cloak of judicial protection surrounding the

Committee's decision to dismiss.

119, 20] First, plaintiff challenges Ms. Kellogg's inde-

pendence on the grounds that while serving as a director in

1976 she voted on the release of the personal guaranty of

Debbie Katz, which event was also considered several years

later by the Committee during Ms. Kellogg’s membership.

Granting that the Committee discussed the board’s appro-

val of the release in its final report, in attempting to impute

bias to Ms. Kellogg because she voted to release a guaran-

tor, plaintiff misunderstands the nature of self-interest suf-

ficient to disqualify a Committee member. So long as

directors serving on the Committee lack direct personal

involvement in the subject matter of the suit, they satisfy

the threshold test of independence. In the instant case, this

means that Ms. Kellogg must be free only from involve-

ment in the transactions relating to the Katz loans. Since

the subject matter of the suit is such loans and not the

release of personal guarantors, there is no merit to plain-

tiffs claim that by participating in the vote to release Deb-

bie Katz, Ms. Kellogg became so interested in the subject

matter of the suit as to warrant a finding of prejudicial

interest.

7. The Committee produced materials including, but not limited to,

Parts I & II of the Special Litigation Committee Report; depositions of

Messrs. Murtha and Brady, counsel to the Committee; depositions of

additional directors; responses to interrogatories by directors, and pro-

duction of responses by thirteen defendants to the Committee's

questionnaire.

To qualify as interested, a Committee member must pos-

sess a direct personal stake in the subject matter being

litigated. Personal involvement may take the form of autho-

rizing the underlying transaction, as in Galef v. Alexander,

supra, 615 F.2d 51, holding a financial interest in the con-

duct at the core of the litigation, as in Lewis v. Anderson,

supra, 615 F.2d 778, or otherwise reaping a tangible

benefit from the challenged activity. Some courts have

found that being named a defendant automatically disqual-

ifies a director on grounds of interest for the obvious reason

that:

Where the directors, themselves, are sub, to personal

liability in the action [they] cannot be expected to deter-

mine impartially whether it is warranted.

Abbey v. Control Data, 603 F.2d 724, 727 (8th Cir. 1979),

citing United Copper Securities Co., supra, 244 U.S. 261, 37

S. Ct. 509, 61 L.Ed. 1119. However, other courts have

allowed a nominal defendant to serve on a special commit-

tee provided the director did not personally gain from the

alleged wrongdoing. Lewis v. Anderson, supra, 615 F.2d at

780.

Ms. Kellogg belongs in none of the foregoing categories.

She was elected to the board on July 21, 1976, and com-

menced service on September 15, 1976; she neither served

on the board during the period of the loans, nor affiliated

with the allegedly culpable officers and directors at the

time under dispute. (Affidavit in Support of the Corpora-

tions’ Motion for Summary Judgment).' Furthermore, Ms.

Kellogg stated in her affidavit that both she and Mr. Trefz

excused themselves from all board consideration of the

merits of the derivative suit once the investigation com-

menced. Her conduct in voting on the release of a guaran-

tor, a matter remotely related to the derivative suit, does

8. Mr. Trefz was also elected to the board after the 1970-75 period

when the loans were extended. He commenced service on January 3,

1977, following his election to the board on December 15, 1976.

B-27

not rise to the level of personal interest sufficient to disqual-

ify Ms. Kellogg or nullify her vote to dismiss.

Plaintiff's second avenue of attack on the issue of good

faith relates to the board's initial refusal to sue, which both

Ms. Kellogg and Mr. Trefz voted upon as board members

prior to their service on the Committee. Plaintiff contends

that any participation at the preliminary stage of the deriv-

ative action is conclusive evidence that both members “pre-

judged” the merits of the case, thereby destroying their

independence. This Court grants that an initial decision by

the board not to sue represents a consensus among the full

board, following demand by the shareholders (unless

demand is excused), that the suit should not be brought by

the corporation. However, that preliminary decision, like

the subsequent decision to terminate an ongoing suit, is not

exclusively a review of the merits, but rather is based on a

variety of factors all relevant to whether the suit serves the

corporation’s best interests. See, e.g. Auerbach, supra, 419

N.Y.S.2d at 928, 393 N.E.2d at 1002. In fact, when a share-

holder first makes demand, little may be known of the sub-

stance of the claims or the potential exposure to the

corporation if found liable. To claim, as plaintiff does, that

the Committee members are presumptively biased by

virtue of their vote to resist shareholder demand is to mis-

understand the concerns of a corporate board faced with

such a demand to sue.

[21] Furthermore, plaintiff has cited no authority which

holds that a director who, in the first instance, votes against

bringing a derivative suit is incapable of rendering an inde-

pendent and detached decision four years later following an

exhaustive investigation. The facts in the instant case high-

light the fallacy of this argument. If Ms. Kellogg and Mr.

Trefz had genuinely prejudged the issues, they would have

sought dismissal of the entire lawsuit. Only complete dis-

missal would have been consistent with the board’s initial

vote against bringing the entire derivative suit in 1977.

B-28

Instead, the Committee chose the course of partial dismis-

sal, which allows the suit to proceed (or be settled) as to

seven defendants. This fact alone belies plaintiff's claims of

improper prejudgment.

[22] Third, plaintiff attacks the good faith of both Ms.

Kellogg and Mr. Trefz for participating in discussions and

voting with the entire board on matters relating to fees

expended in defense of the derivative action. Plaintiff has

offered no explanation and this Court fails to see how their

independence has been compromised for this reason. As

part of their responsibility to assess the harm and benefit to

the corporation resulting from the suit, Ms. Kellogg and

Mr. Trefz were clearly obligated to consider the cost of the

litigation to the Corporation. Perhaps the best source of

that information is the board meeting, which Committee

members continue to attend and in fact must so attend as

part of their fiduciary duties as directors. It is only by con-

stant interaction with the full board that a thorough investi-

gation can be conducted, despite plaintiff's preference for

complete insulation of the Committee from the remaining

directors.

Plaintiffs remaining challenges to the Committee’s bona

fides are elaborations of points already considered. Essen-

tially, plaintiff claims that Ms. Kellogg and Mr. Trefz were

at all times predisposed to protect the interests of their

co-directors, who obviously opposed the suit and hoped the

Committee would follow the path of other independent com-

mittees in recommending dismissal. According to plain-

tiffs theory, a director who maintains an ongoing personal

or professional relationship with directors facing liability is

per se incapable of reaching an impartial] decision. Each of

these arguments reduces to the same proposition that the

structure of the corporate entity renders it impossible for a

director to decide the fate of a derivative suit against other

directors in a neutral fashion. As this Court has already

B-29

held, absent concrete proof of actual bias or interest, there

is simply no basis to accept plaintiff's “vigorous and imagin-

ative hypothesizing” as sufficient to raise a triable issue of

fact as to either the disinterest of the Committee members

or the independence of the investigation. Auerbach, supra,

419 N.Y.S.2d at 927, 393 N.E.2d at 1001.

Based on this Court’s review, not a scintilla of evidence

has been offered to prove interest or bias on the part of the

Committee members. If anything, the record in the instant

case refutes plaintiff's allegations, based on the single fact

that although the Committee had the power under the state

business judgment rule to dismiss the entire suit, it

declined to do so. Instead, the Committee voted to continue

or settle the suit as to certain defendants. More than any

other fact in this voluminous record, it is this limited exer-

cise of the Committee’s discretion which substantiates its

good faith.

Finally, to complete this Court’s review, it has found no

evidence of infirmities in the Committee’s procedures nor

any factual deficiencies in its findings. Perhaps this is

because the thoroughness of the investigation is self-

evident. According to affidavits filed by Committee

members and counsel, each member devoted a minimum of

100-125 hours to the investigation, while counsel spent an

additional 1400 hours. The Committee met seventeen times

in formal session and conferred informally on other occa-

sions. Furthermore, based on this Court’s careful review of

the report, it is apparent that the Committee interviewed

witnesses, consulted with experts, submitted question-

naires to directors and reviewed a plethora of documents.

Plaintiff at no point challenges the Committee’s thorough-

ness, but instead rejects its conclusions. This Court has

found however, that the business judgment rule forbids dis-

turbing the Committee’s substantive conclusions, regard-

less of whether a court or shareholder would have decided

the issues differently. To do so would emasculate the busi-

B-30

ness judgment rule which insulates the Committee’s deci-

sion froin further judicial scrutiny once there has been a

finding of good faith and thoroughness.’ Having found no

material dispute as to the integrity of the Committee’s

investigation, this Court is compelled to accept its business

judgment determination to dismiss the derivative suit

against the twenty-three designated defendants.

[23] For the foregoing reasons, each of the three prereq-

uisites to dismissal as set forth in Burks have been satisfied;

the Committee was established in a manner fully consistent

with all relevant state and federal law and the final deci-

sion is the product of a comprehensive investigation under-

taken by disinterested directors in good faith. Accordingly,

the motion for summary judgment is hereby granted.

It is So Ordered.

9. In so holding, this Court disagrees with the approach recently

adopted by the Delaware Supreme Court in Zapata v. Maldonado,

supra, at 788-789, wherein the Chancery Court was ordered to render

its own business judgment to determine whether the suit should be

dismissed. If the purpose of the business judgment rule is to allow those

with the expertise, i.e. the directors, to govern the corporation consist-

ent with its best interest, then neither shareholders nor the courts

should be free to second-guess the directors. There is simply no basis to

assume that a court is more qualified than the directors or the share-

holders to assess the merits and value of a derivative suit to the corpora-

tion. To the contrary, a court, which has the duty of exercising “judicial

judgment”, has no business interfering with the exercise of “business

judgment.”

C-1

APPENDIX C

UNITED STATES Court OF APPEALS

SECOND CIRCUIT

December 21, 1982

At a stated term of the United States Court of Appeals, in

and for the Second Circuit, held at the United States Court

House, in the City of New York, on the twenty-first day of

December, one thousand nine hundred and eighty-two.

No. 81-7729

ATHALIE Doris Joy,

Plaintiff-A ppellant,

V.

NELSON L. Nokrn, et al.,

Defendants-A ppellees.

Petitions for rehearing containing suggestions that the

action be reheard in banc having been filed herein by coun-

sel for the defendant-appellee, Citytrust, and by counsel for

the nineteen (19) individual appellees,

Upon consideration by the panel that heard the appeal,

it is

Ordered that said petitions for rehearing are DENIED,

Judge Cardamone dissenting.

It is further noted that the suggestions for rehearing in

banc have been transmitted to the judges of the court in

regular active service and to any other judge on the panel

that heard the appeal and that no such judge has requested

that a vote be taken thereon.

A. DANIEL Fusaro, Clerk

by FRANCIS X. GINDHART,

Chief Deputy Clerk

Ra

D-1

| APPENDIX D

Rule 23.1. Derivative Actions by Shareholders

In a derivative action brought by one or more share-

holders or members to enforce a right of a corporation or of

an unincorporated association, the corporation or associa-

tion having failed to enforce a right which may properly be

asserted by it, the complaint shall be verified and shall

allege (1) that the plaintiff was a shareholder or member at

the time of the transaction of which he complains or that his

share or membership thereafter devolved on him by opera-

tion of law, and (2) that the action is not a collusive one to

confer jurisdiction on a court of the United States which it

would not otherwise have. The complaint shall also allege

with particularity the efforts, if any, made by the plaintiff

to obtain the action he desires from the directors or compar-

able authority and, if necessary, from the shareholders or

members, and the reasons for his failure to obtain the

action or for not making the effort. The derivative action

may not be maintained if it appears that the plaintiff does

not fairly and adequately represent the interests of the

shareholders or members similarly situated in enforcing

the right of the corporation or association. The action shall

not be dismissed or compromised without the approval of

the court, and notice of the proposed dismissal or compro-

mise shall be given to shareholders or members in such

manner as the court directs.