DocketNumber: No. CV89-0265920
Citation Numbers: 1991 Conn. Super. Ct. 4430, 6 Conn. Super. Ct. 588
Judges: NIGRO, J.
Filed Date: 5/17/1991
Status: Non-Precedential
Modified Date: 4/18/2021
The plaintiffs have filed an amended complaint in which they claim that the individual defendants had breached their fiduciary duties, were grossly negligent, and had caused the waste of corporate assets in their functions of oversight, management and control of Citytrust's loan portfolio and lending activities. Plaintiffs allege that the breach of duty was especially manifest in permitting extensive high-risk, shared-appreciation loans to be made where the borrowers did not even have to make a minimal equity investment and in permitting other imprudent acquisition, development and construction arrangements. Plaintiffs claim that, as a result of defendants' grossly negligent conduct in managing the bank's loan portfolio, Citytrust has already reported over $140,000,000 of losses. The plaintiffs assert that Citytrust is now saddled with CT Page 4431 non-performing assets in excess of the amount of its shareholders' assets and its continued existence is imperiled. The plaintiffs also claim that Citytrust has been subjected to federal securities law class action suits in which serious charges have been made regarding the completeness and accuracy of its disclosures. If such charges are sustained, the plaintiffs allege that Citytrust's auditor would be similarly implicated in such violations.
The action seeks to hold the directors and the auditor personally liable for loan losses and the plaintiffs seek to recover, on behalf of Citytrust, damages for those losses from these defendants and indemnification from them for any losses that may result from actions against Citytrust arising out of the loan decisions.
The individual defendants filed a motion to strike the amended complaint, arguing that the plaintiffs failed to make a demand on the board of directors to institute this suit, which they allege is a requisite condition precedent to any derivative action. In addition, the individual plaintiffs allege that the plaintiffs have failed to plead, nor can they plead, allegations necessary to excuse demand upon the board. Anderson filed a similar motion.
The plaintiffs responded by objection to these motions arguing that the demand requirement should be excused as futile and that they have established adequate probable cause in their allegations to excuse demand on the board before bringing this action.
Although there is a paucity of Connecticut cases dealing with shareholders' derivative suits, it is clear that such suits have also long been recognized in this State. Allen v. Curtis,
However, to prevent derivative actions from undermining the CT Page 4432 corporate form of conducting business, the United States Supreme Court, in Hawes, approved a requirement that demand first be made upon the board of directors to bring the action which the shareholder claims should be maintained. "`[B]efore the shareholder is permitted in his own name to institute and conduct a litigation which usually belongs to the corporation, he should show to the satisfaction of the court that he has exhausted all the means within his reach to obtain within the corporation itself, the redress of his grievances, or actions in conformity with his wishes.' [Hawes v. Oakland, 104 (14 Otto) U.S. 450] at 460-461. In other words, forcing shareholders to exhaust intra-corporate remedies by making demand on directors allows the directors a chance to occupy their proper position as managers of the corporation's business, giving the corporations an opportunity to take control of a suit that will be brought on its behalf." Mozes on Behalf of General Electric Co. v. Welch,
"[C]ourts should not interfere . . . nor should they sanction the interference by shareholders with the duties of the board of directors unless it is clear that the board has no intention of taking the appropriate action itself." Brooks v. American Export Industries, Inc.,
Because of this reluctance to interfere with the usual conduct of corporate business, there is a consensus among the jurisdictions which have considered the issue, that a shareholder must either make a demand on the board or in the complaint plead with particularity the exceptional circumstances that demonstrate why such a demand would be futile. See, De Mott, Shareholder Derivative Actions: Law and Practice, Sec. 5:03 (1987).
This consensus is reflected in Rule
"The complaint shall also allege with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors or comparable authority and, if necessary, from the shareholders or members, and the reasons for the plaintiff's failure to obtain the action or for not making the effort."
There appears no dispute that the substantive allegations of the complaint do not allege self-dealing or fraud on the part of members of the board, but are based primarily on the claim of gross negligence by the board in its administration and supervision of the bank's loan portfolio.
The plaintiffs in this action do not disagree with the general requirement that demand on the board is a usual prerequisite for maintaining a derivative action. The plaintiffs, however, have set forth their reasons for claiming that demand in this case is futile in paragraph 9 of the amended complaint.
"9. Plaintiffs have not made any demand on the present Board of Directors of Citytrust to institute this action because such demand would be a futile and useless act for the following reasons:
(a) Citytrust has been forced to incur at least $140 million in losses recognized in 1989 and the first quarter of 1990 as a result of the Officer/Director Defendants' gross negligence in failing to properly supervise and manage Citytrust's loan portfolio and lending activities;
(b) The Officer/Director Defendants cannot defend their actions by any alleged "independent" business judgment because each of them is responsible for the current financial condition of Citytrust, each has acted or failed to act in gross negligence, and each would be adversely affected if the action were brought, because each would be required to sue himself;
(c) The acts complained of herein constitute violations of CT Page 4434 fiduciary duties owed by Citytrust's Board of Directors and these acts are incapable of ratification;
(d) Because of their active participation in the management and supervision of Citytrust, the Director defendants are in no position to prosecute this action. Each of them is in an irreconcilable conflict of interest in terms of prosecution of this action;
(e) The known principal wrongdoers and beneficiaries of the wrongdoing complained of herein are in a position to, and do, dominate and control the Citytrust Board of Directors. Thus, the Board could not exercise independent objective judgment on deciding whether to bring this action nor to vigorously prosecute this action;
(f) Citytrust maintains policies of insurance for itself to cover the costs of indemnification of each of the Officer/Director defendants and of damages from the Officer/Director Defendants' negligence and mismanagement. Under the terms of any such insurance policies, Citytrust would be required by the carriers to cooperate in the defense of any claims, such as the present action. Thus, defendants could be contractually obligated to ignore any demand that would cause Citytrust to institute and/or prosecute any action against the Officer/Director Defendants for mismanagement because to do so could result in the loss of its insurance coverage. Similarly, Citytrust would be disabled contractually from pursuing the Officer/Director defendants directly as it would not benefit from any coverage they may have;
(g) To the extent that the officers and directors have liability insurance coverage, a typical exclusion from such coverage is a claim brought by Citytrust against its own officers and directors;
(h) The acts complained of herein, and the expenditure of funds complained of, constitute a waste of Citytrust's assets, and thus are acts incapable of ratification;
(i) In order to bring this action for breach of fiduciary duty and gross negligence, the members of the Citytrust Board of Directors would have been required to sue themselves and/or their fellow directors and allies in the top ranks of the corporation, who are their good friends and with whom they have entangling financial alliances, interests, and dependencies, which they would not do. They therefore would not be able to vigorously prosecute any such action; and
(j) The members of the Citytrust Board of Directors, CT Page 4435 including each of the defendants herein, receive from Citytrust and its subsidiaries substantial fees' bonuses, payments, benefits, and other emoluments by virtue of their membership on the Board and their control of Citytrust. They have thus benefited from the wrongs herein alleged and have engaged therein to preserve their positions of control and the perquisites thereof, and are incapable of exercising independent objective judgment in deciding whether to bring this action. The Board members also have close personal and business ties with each other and are, consequently, interested parties and cannot in good faith exercise independent business judgment to determine whether to bring this action against themselves.
The defendants' position with regard to the issue of futility is that "[i]n Connecticut, as in the majority of other jurisdictions, demand may not be excused for futility in the absence of specific allegations of fraud or self-dealing." (See, Individual Defendants' Memorandum at page 7.) The defendants assert that because there is no allegation in the amended complaint that the defendants committed fraud or had a personal interest in the loans challenged in the complaint, or that they received fees or commissions in connection with the loans, or that they otherwise profited in any way from the loans, but merely a claim of gross negligence in their function as officers and directors, there is no basis for excusing demand. The defendants contend that an action based primarily upon alleged negligence, even gross negligence, of the board does not support a waiver of the demand requirement.
The plaintiffs assert that allegations of gross negligence as claimed in the complaint when set forth with particularity excuses demand.
In examining that precedent, it must be noted that there has been conflict among the federal courts as to what law determines the sufficiency of an excuse. Some courts, such as the Third Circuit, have used state substantive law to determine whether to excuse demand. Lewis v. Curtis,
Nonetheless, "most federal courts have applied federal law to determine if the demand requirement has been satisfied." Matter of Consumers Power Co. Derivative Litigation,
However, some federal courts have applied state law, such as that of Delaware, which could excuse demand for claimed breach of the duty of loyalty or care, provided the plaintiff is persuasive that the so-called "business judgement rule" is not applicable as a shield. See, e.g., Aronson v. Lewis,
As indicated, federal courts generally excuse demand only when particularized allegations of fraud or self-dealing by a board majority indicate demand would be futile.
Those courts which require allegations of fraud or CT Page 4437 self-dealing before excusing demand usually require that the acts of the board be more than acquiesence in or approval of the alleged wrongdoing. "Absent specific allegations of self-dealing or bias on the part of a majority of the board, mere approval and acquiescence are insufficient to render demand futile." Lewis v. Graves,
In the Mozes case, supra, demand was not excused because the plaintiff failed to allege with particularity any self-dealing, bias, bad faith, or corrupt motive.
In considering what degree of particularity is required, the federal courts apply a federal law standard. "[T]he substantive law of the state of incorporation should govern whether demand is sufficient or excused [but] . . .federal law should determine whether the plaintiffs' demand or excuse has been pled with particularity sufficient to meet the requirements of the Federal Rule of Civil Procedure." In Re Bankamerica Securities Litigation,
In reviewing the standards of those jurisdictions which require particularized allegations of bias or self-dealing, it appears that merely charging the directors with approving the challenged conduct or failing to correct the conduct is insufficient. Lewis v. Graves, supra, at 249.
Instead, the plaintiff must show personal benefit to the majority of the board, In Re E.F. Hutton Banking Practices Litigation,
In Lewis v. Graves, supra, the plaintiff in a derivative suit argued that demand was excused because the board had previously approved the challenged transaction. The court CT Page 4438 disagreed, however, explaining that "bald charges of having approved the alleged wrongdoing [are] inadequate to demonstrate futility." Id, at 245. On the other hand, in Cathedral Estates v. Taft Realty Corp., supra, the Second Circuit court of Appeals upheld the Connecticut District Court's excuse of demand. The court there found that the defendants were actively involved in the challenged illegal conduct because "they were the prime movers in the transaction." Id, at 88.
The court in Oldfield v. Alston, supra, also excused demand because the directors either actively participated or "approved or ratified [the] transactions with knowledge or notice of their illegality." Id, at 740. The transactions in that case transcended mere acquiescence because they involved specific SEC violations; illegal conduct, not merely unwise or negligent.
Papilsky, supra, also involved illegal acts — violations of SEC regulations.
In Barr v. Wackman, supra, a case decided under New York state law, the court excused demand because the plaintiff alleged the existence of a "plan and scheme" by which the defendant directors derived personal benefit to the exclusion of the corporation. In that case, the New York court determined that the complaint specifically pleaded "board participation in and approval of active wrongdoing." Barr, supra, at 508.
In In Re E.F. Hutton Banking Practices Litigation,
In Lewis v. Anselmi,
The court in Lewis v. Sporck,
In Heit v. Baird,
A transaction is undirected to a corporate purpose when it is facially improper and advantageous only to the directors. In Re Kauffman Mutual Fund Actions,
It is generally held that allegations must be factually explicit and conclusory allegations are insufficient to show futility. Heit v. Baird, supra, at 1161.
In Mozes on Behalf of General Electric Co. v. Welch,
The plaintiff's allegations in Lewis v. Graves,
Moreover, in most courts which have addressed the issue, including those which follow the Delaware rule, simply naming the directors as defendants does not excuse demand. "To construe it as sufficient would mean that plaintiffs could readily circumvent the demand requirement merely by naming as defendants all members of the derivative corporations's board." Lewis v. Graves,
The court in Aronson discussed the board's duty of care under the so-called "business judgment rule" as follows:
Second, to invoke the rule's protection directors have a duty to inform themselves, prior to making a business decision, of all material information reasonably available to them. Having become so CT Page 4441 informed, they must then act with requisite care in the discharge of their duties. While the Delaware cases use a variety of terms to describe the applicable standard of care, our analysis satisfies us that under the business judgment rule director liability is predicated upon concepts of gross negligence. . .
However, its should be noted that the business judgment rule operates only in the context of director action. Technically speaking, it has no role where directors have either abdicated their functions, or absent a conscious decision, have failed to act. But it also follows that under applicable principles, a conscious decision to refrain from acting may nonetheless be a valid exercise of business judgment and enjoy the protection of the rule.
Id. at 812-13 [Citations and footnotes omitted].
Despite its treatment of the duty of care, the court determined that the allegations of fact "`show that there is a reasonable inference' the business judgment rule is applicable for purposes of a pre-suit demand." Id. at 814. The plaintiff had argued that demand would be futile because the directors acquiesced in the transaction, the board was dominated, and the defendants would be required to sue themselves. The court held that a demand is futile only when a "reasonable doubt is created that: (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment." Id. at 814. Thus, the court created a two-tiered test whereby:
the court of Chancery must make two inquiries, one into the independence and disinterestedness of the directors and the other into the substantive nature of the challenged transaction and the board's approval thereof. As to the latter inquiry the court does not assume that the transaction is a wrong to the corporation requiring corrective steps by the board. Rather, the alleged wrong is substantively viewed against the factual background alleged in the complaint. As to the former inquiry, directorial independence and disinterestedness, the court reviews the factual allegations to decide, whether they raise a reasonable doubt, as a threshold matter, that the protections of the business judgment rule are available to the board. CT Page 4442
It would appear that in a jurisdiction adopting the Aronson rule, any claims of negligence necessarily require analysis under the business judgment prong. This is supported by subsequent cases in Delaware and among the federal circuits. See, for example, Pogostin, supra, at 624, where, citing its decision in Aronson, the Delaware court reiterated that demand futility is tied to the business judgment rule.
The business judgment rule provides that directors or officers will not be held liable for breach of fiduciary duty to a corporation or its stockholders for mistakes of fact or law that cause harm to the corporation or its stockholders, if the directors acted in good faith. "Under the `business judgment doctrine', acts of directors, within the powers of a corporation, in furtherance of its business, made in good faith and in the exercise of honest judgment, are valid and conclude the corporation and its stockholders; questions of management policy, contract expediency, and adequate consideration are left to the directors honest and unselfish decision, judgment and discretion and may not be interfered with or restrained. Hermione v. American Express Co.,
In Cottle v. Hilton Hotel Corp.,
In Tabas v. Mullane,
The District court of California, in applying Delaware law, determined that a derivative complaint must "specifically identify what it is about the transactions that creates a reasonable doubt as to the applicability of the business judgment rule. . ." In Re Bankamerica Securities Litigation,
In In Re General Motors Class E Stock Buyout Sec. Lit.,
The court in Cramer v. General Telephone Electronics Corporation,
While it is true that the court in Walden v. Elrod,
The plaintiffs in the instant case allege that demand would be futile for the following reasons: (1) defendants were grossly negligent "in failing properly to supervise and manage Citytrust's loan portfolio and lending activities;" (2) each director/defendant was grossly negligent in acting or failing to act and would be required to sue himself and his associates; (3) defendants breached their fiduciary duty; (4) the "wrongdoers" dominate the board; (5) Citytrust's indemnity insurance contract would require it to "ignore any demand;" and (6) the challenged conduct constitutes a waste of corporate assets.
Despite their recitation of offenses, the plaintiffs are really offering only conclusory allegations as to the claim of negligence. Moreover, they fail to provide allegations of personal interest or benefit sufficient to waive the demand requirement. As discussed above, receiving normal directors fees does not constitute personal interest. Again, the plaintiffs failed to allege any conflict of interest or self-dealing behavior that would suggest a breach of fiduciary duty. The business judgment rule allows the directors to make even bad business decisions absent bad faith. The plaintiffs have pleaded no facts regarding bad faith.
Despite Citytrust's allegedly improvident lending practices, the plaintiffs failed to show that the board's actions constituted "wrongful conduct," for example, clandestine activity or fraud. Moreover, whether the "wrongdoers" dominated the board depends on whether wrongful conduct was alleged in the first place. Aside from imprudence, however, the plaintiffs failed to allege with particularity that Citytrust's directors behaved fraudulently, were self-dealing, or violated the business judgment rule. The cases cited above clearly demonstrate that demand may not be excused simply by naming the directors as defendants and then allege that they would be required to sue themselves. In addition, it is ingenuous to claim that maintaining insurance was not a valid exercise of business judgment. In Walner v. Friedman,
The early Connecticut cases cited by the plaintiffs do not sustain their claim that this state will excuse demand when the allegation in the action are based on purported gross negligence. CT Page 4445
It is true that the Supreme Court of Connecticut early recognized derivative action by minority stockholders as an appropriate action. Sears v. Hotchkiss,
The Connecticut Supreme court has also allowed that demand is excusable when demand is futile. Sheehy v. Barry,
However, the plaintiff in Sheehy alleged that suspended officers and board members made an unlawful agreement with the sitting board members to usurp the company's premises and defraud the plaintiff and creditors of the corporation's assets. Thus, the plaintiff alleged that the defendants engaged in unlawful conduct amounting to criminal acts. It does not appear that Sheehy involved gross negligence as the Nobles allege to be the subject of the case presently at bar. Moreover, the exception for fraud and mismanagement was cited by the Sheehy court regarding a prayer for dissolution, not a demand excuse.
The plaintiffs cite Allen v. Curtis,
In the Shepaug Voting Trust Cases,
The plaintiffs put great emphasis on Joy v. North,
The court also stated that demand is excused when the directors and officers are defendants, Id, at 889. This statement was dicta so far as it related to the plaintiff's standing, since demand had in fact been made. The assertion goes against the weight of case law cited previously.
The plaintiffs in Joy had in fact made a demand and the issue was whether the Special Litigation Committee established by the board as a response to that demand used proper judgment in deciding not to recommend litigation. Thus, the business judgment rule at issue in Joy was the propriety of the board's decision not to acquiesce in the demand upon the recommendation of its special committee not to pursue litigation.
". . . [W]e 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." Id. at 889.
The issue as stated by the plaintiffs in the present litigation is whether the board used improper business judgment in running and supervising Citytrust's lending practices so as to excuse demand.
The plaintiffs have called to the court's attention the recent decision of the Second Circuit Court of Appeals in the case of RCM Securities Fund, Inc., et al. v. E. Douglas Stanton, et al., decided March 26, 1991 and have provided the court with a copy of the slip opinion. In that case, the Circuit Court reversed the District Court's dismissal of a derivative action for lack of demand. Applying Delaware law, the Circuit Court held that demand was excused. "Demand is thus excused under Delaware law because the particularized allegations of the complaint create a reasonable doubt as to whether the directors exercised substantive care." Id., at 38.
The case involved the purchase of 96,461 shares of company stock (being 39.2 percent of the outstanding common stock) from the estate of the company's founder (Rhodes) and of an additional 26,800 shares from the estate of another substantial shareholder (Lerner). The board of directors arranged for the purchase of these shares at a substantial premium over market CT Page 4447 and the transfer of the shares to the company's non-contributory Employee Stock Ownership Plan (ESOP) in which top management participated.
To fund the purchase, the directors authorized a loan of $2.55 million and a cash contribution of $175,000 to the ESOP. The loan was financed by a borrowing from a Connecticut bank which was secured by a mortgage on the company's real property. The transaction had the effect of shifting control of the corporation to the ESOP.
The Circuit Court indicated that "[t]he relevant question under Delaware law is `whether what the corporation has received is so inadequate in value that no person of ordinary, sound business judgment would deem it worth that which the corporation had paid.' Grobow,
The Court noted the particularized allegations of facts in the amended complaint several times during the opinion. Applying the Aronson test, the court determined that "Delaware law excuses the failure to make a demand when, inter alia, particularized allegations in the complaint raise a reasonable doubt as to whether the directors exercised proper business judgment. Because we conclude that the allegations in the instant complaint suffice to create such a reasonable doubt, we reverse on the appeal." Id., at 3.
The court stated: "The waste issue comes down to whether, giving full measure to all the presumptions favoring the decision of an independent board, the benefits of the expected increase in productivity attendant to the vesting of control in the ESOP bear any reasonable relation to the costs of the transactions in question. We believe that the disproportion between the serious financial weakening of the company and any reasonable expectation of increased productivity is so glaring that the transactions as alleged amounted to a gratuity of one-third of the assets to top management. We know of no presumption that would permit us without more to indulge in the belief that such a loss can be offset by increasing productivity among top management." Id., at 34.
An examination of the particularized factual allegations in RCM Securities Fund, as summarized by the Circuit Court, with the allegations made in the instant complaint can only emphasize the distinction between particularized factual allegations and CT Page 4448 conclusory allegations.
The most persuasive allegation made by the plaintiffs in the present case is that the directors "failed to remain informed as to how Citytrust and its subsidiaries were, in fact, operating and, upon receiving notice or information of an unsafe, imprudent or unsound practice, to make a reasonable investigation therewith and to take steps to correct that condition or practice." Amended Complaint, paragraph 31(e). However, the allegation is patently conclusory and lacking in any supportive particularity adequate to overcome the protection of the business judgment rule so as to justify excusing demand.
The case of Starrels v. First National Bank of Chicago,
So, even under the Aronson analysis, the allegations of negligence in the present suit have not been pleaded with the particularity necessary to overcome the presumptions of the business judgment rule and are therefore not sufficient to excuse demand.
The court finds that the plaintiffs have failed to allege with particularity allegations which, under Connecticut law, would excuse them from making demand on the board to initiate this litigation, a condition precedent to the plaintiffs' standing to maintain a derivative suit on behalf Citytrust.
The motion to strike the amended complaint is granted.
NIGRO, J.
Fed. Sec. L. Rep. P 96,297 Charles Heit v. Walter S. Baird , 567 F.2d 1157 ( 1977 )
In Re Kauffman Mutual Fund Actions. Joseph B. Kauffman , 479 F.2d 257 ( 1973 )
Cathedral Estates, Inc. v. The Taft Realty Corporation , 228 F.2d 85 ( 1955 )
harry-lewis-v-henry-curtis-albert-f-duval-roger-s-ahlbrandt-fred , 671 F.2d 779 ( 1982 )
Fed. Sec. L. Rep. P 98,860 Athalie Doris Joy v. Nelson L. ... , 692 F.2d 880 ( 1982 )
fed-sec-l-rep-p-96510-harold-cramer-custodian-for-patricia-gail , 582 F.2d 259 ( 1978 )
Saxe v. Brady , 184 A.2d 602 ( 1962 )
Aronson v. Lewis , 473 A.2d 805 ( 1984 )
Barrett v. Southern Connecticut Gas Co. , 172 Conn. 362 ( 1977 )
Pogostin v. Rice , 480 A.2d 619 ( 1984 )
Sheehy v. Barry , 87 Conn. 656 ( 1914 )
In Re Kauffman Mutual Fund Actions (Joseph B. Kauffman, ... , 414 U.S. 857 ( 1973 )