RULING BOOSTS PROTECTION FROM DERIVATIVE ACTION SUITSPosted On: May. 4, 1997 12:00 AM CST
PHILADELPHIA-A first-of-its-kind ruling by the Pennsylvania Supreme Court gives corporations greater authority to block derivative-action lawsuits.
The decision likely will influence many courts, but it probably will not sway courts in the prime business domiciles of Delaware and New York, say directors and officers liability attorneys.
In its April 21 unanimous ruling, Pennsylvania's highest court became the first state supreme court to adopt American Law Institute principles that call for providing company officials greater protection against derivative litigation when shareholder allegations arise from management's poor business judgment but not malfeasance.
Plaintiffs attorneys hotly contested the ALI's principles as too pro-business when the Philadelphia-based non-profit legal research organization adopted them in 1992.
The principles are designed to eliminate a problem "courts have grappled with for decades" in such litigation, said policyholder attorney Lowell Sachnoff, a member of the ALI team that suggested the principles.
In most jurisdictions, shareholders seeking to file derivative claims first must demand that their company's board both investigate their allegations and take the lead in filing suit against the company officials who allegedly committed wrongful acts. Wrongful acts, though, do not include harmful actions that company officials judged at that time were in the company's best interests.
After a thorough investigation by company officials who would not be parties to the derivative litigation, a board may decide to either file a lawsuit or reject the shareholders' demand, which is known as "demand refused."
But, in cases referred to as "de-mand excused," shareholders can skip issuing a demand to the board or still pursue their claim in court even after their board rejects their demand. To keep their lawsuits alive, shareholders would have to show a court that their demand would be or was futile because a majority of the board allegedly engaged in the wrongful activity and could not evaluate the demand objectively.
If a derivative lawsuit survives, judges in many jurisdictions may not rely on their own business judgment to second-guess the judgment of company officials. Instead, shareholders bear the burden of showing that company officials knowingly did not act in the organization's best interests.
A notable exception exists in Delaware, where judges in the trial-level Chancery Court may substitute their own business judgment in place of the board's. Courts in a few other states are set up similarly.
The ALI principles were designed to eliminate the distinctions between the "demand refused" and the "demand excused" cases, said Mr. Sachnoff, a partner with Sachnoff & Weaver Ltd. of Chicago.
Under the ALI's principles, a board has much broader power in refusing to press a shareholder's claim and in preventing the shareholder from pursuing his lawsuit without the board's backing.
In adopting the ALI principles, the Pennsylvania Supreme Court:
Gave boards of Pennsylvania companies the automatic right to review a derivative-action claim under most circumstances. The lone exception is when a shareholder can show that the corporation otherwise would suffer "irreparable injury."
Stayed suits by shareholders until their board completes its investigation of their claims.
Required lower courts to uphold the decisions of boards' special committees to terminate derivative litigation, if those committees followed prescribed procedures for investigating shareholder complaints.
The court's 6-0 decision came in derivative litigation filed against Peco Energy Co., a Philadelphia-based gas and electric utility.
Shareholders alleged the utility mismanaged its collection function for years by not aggressively pursuing delinquent accounts.
In consultation with attorneys, a special committee consisting of a dozen Peco board members who were not named defendants outlined in a 300-page report why it concluded the charges were meritless. For example, the committee found the state utility commission was more receptive to Peco's rate hike requests after the utility ratcheted down its collection attempts against delinquent customers, many of whom are impoverished.
The Supreme Court's decision overturned two lower court rulings against Peco. Though Pennsylvania courts never used the term "business judgment," the Supreme Court found that the context of state court rulings dating to the 18th Century provided company officials protection under the business judgment doctrine.
That ruling by itself was "significant," said Marc J. Sonnenfeld, a partner with Morgan, Lewis & Bockius L.L.P. of Philadelphia, which filed an amicus brief in the case for three business groups in the state. A contrary ruling "would have made Pennsylvania law aberrational" compared with case law in other states, he said.
Supreme Court Chief Justice John Flaherty explained that the court went further and adopted the ALI principles because the lower courts demonstrated they need guidance in this area.
The judge did not limit his criticism to Pennsylvania courts. He took a swipe at the Delaware courts for allowing judges to substitute their own business judgment for company officials'. He also criticized New York courts for not establishing procedures to govern corporate decisions in derivative litigation. Some attorneys disagreed with the judge's assessment about New York Courts.
The Peco case was remanded to a trial court to decide whether the utility's board conducted a fair investigation of its shareholders' claims.
Peco shareholder attorney Ruthanne Gordon, a partner with Berger & Montague of Philadelphia, said the ruling "is contrary to the law in a number of jurisdictions, including Delaware and New York."
Case law in both states allow shareholders to pursue derivative litigation on their own when they allege the majority of their board engaged in grossly negligent conduct, she said. Those courts have ruled that abdication of a board's function, which occurs when a board fails to correct a long-standing problem at the company, constitutes gross negligence, she said.
Courts in many other states likely will follow the Pennsylvania Supreme Court's lead, attorneys agree.
Considering the controversy over the principles in 1992, their adoption "by a major state is of substantial significance," said Peco attorney Alan J. Davis, a partner with law firm Ballard Spahr Andrews & Ingersoll in Philadelphia.
Courts nationwide will continue to follow Delaware court rulings more closely in general, but the Peco decision "will be persuasive and will be cited and looked at closely," predicted insurer attorney Dan A. Bailey, a partner with Arter & Hadden in Columbus, Ohio.
The decision, though, likely will not influence Delaware and New York courts, attorneys said."It would be a radical change in Delaware," Mr. Sachnoff pointed out.
More likely, if courts nationwide begin adopting the ALI principles, Delaware's Legislature would codify the ALI principles to maintain the state's attraction as a corporate domicile, according to policyholder attorney Larry S. Gangnes, a partner with Lane Powell Spears Lubersky L.L.P. in Seattle.
Most importantly for companies, the Pennsylvania case emphasizes the importance of investigating every shareholder's claim, Mr. Bailey said.
He advised boards not to cut corners. "You jeopardize your ability to get out of the case quickly and cost-effectively. Saving a few thousand dollars on the front end may cost you millions in the long run," he said.
Meanwhile, Chubb Corp. has announced that its D&O liability policies now will provide first-dollar coverage of a board's cost to investigate shareholder claims. It said traditional D&O policies typically have not covered those costs.
But, policyholder attorney Carolyn Rosenberg of Sachnoff & Weaver said that other policies implicitly may cover those costs.
"To the extent that the policy language and defense costs include investigation of claims made and allegations of potential wrongdoing by directors and officers, if the investigation of the claims is in defense of innocent directors and officers, then it very well may be a defense cost," she said.
In addition, if the materials produced by the board's investigation committee assist the company in defending or settling other claims, then the company's D&O insurance may cover the cost of producing that material, Ms. Rosenberg said.
Albert Cuker et al. derivatively on behalf of Peco Energy Co. vs. Albert G. Mikalauskas et al., Supreme Court of Pennsylvania; No. 115 Eastern District Miscellaneous Docket 1996.