Opinion
76 Civ. 2296 (GLG)
January 24, 1979
GARWIN BRONZAFT, ESQS., Attorneys for Plaintiff, New York, N.Y., Sidney L. Garwin, Esq., Bruce E. Gerstein, Esq. Of Counsel
KISSAM, HALPIN GENOVESE, ESQS., Attorneys for Defendant, TRW, Inc., New York, N.Y., Leo T. Kissam, Esq., Maryann Johnson, Esq., Of Counsel
DAVIS, POLK WARDWELL, ESQS., Attorneys for Individual Defendants, New York, N.Y., S. Hazard Gillespie, Esq., Sheila McMeen, Esq., Paul R. Koepff, Esq., Of Counsel
OPINION
This action is a shareholder derivative suit against present and former directors of TRW, Inc., brought by plaintiff, Gabriel Galet, trustee of a trust holding TRW stock. The case involves TRW stock options which fell "underwater," that is, the market price of the stock fell well below the price at which the options were exercisable, rendering the options worthless as inducements for employees.
The complaint alleges that TRW and its shareholders were harmed in that two grants of stock options, made on May 1, 1974 and October 30, 1974, were merely modifications of existing options and were undertaken, without shareholder approval, to reduce the price of such options to TRW's employees. Defendants argue that the 1974 options were newly granted options, fully authorized and within the contemplation of the 1967 and 1973 stockholder-approved option plans.
Plaintiff's complaint further alleges that the share limitation for which options could be granted under the existing plans was exceeded; that the 1974 grants were made without consideration and constitute a gift and waste of corporate assets; that the members of TRW's stock option committee have breached their fiduciary duty to the corporation and its shareholders in making the 1974 grants; that the 1967 and 1973 proxy statements, which procured shareholder approval of the 1957 and 1973 plans, were, in light of the action subsequently taken, false and misleading, in violation of section 14(a) of the Securities Act of 1934 (the "1934 Act"), and, that the 1974, 1975 and 1976 proxy statements, issued for the purpose of electing directors, were false and misleading, in violation of the 1934 Act, in failing to reveal the foregoing.
Essentially, the relief sought is as follows: to have the 1974 options voided; to have the directors account for any losses realized by TRW as a result of the lowering of option prices; and to have the elections of directors for 1974, 1975 and 1976 declared void.
The plaintiff made a demand on the board, pursuant to Fed.R.Civ.P. 231, requesting that this action be instituted by the corporation. On December 15, 1976, by a vote of the nine board members who were not option recipients, and who constituted a majority of the entire board, it was resolved that the proposed action was contrary to the best interests of the corporation and should not be pursued. Upon denial of the demand, the action was instituted by plaintiff. Discovery was granted on the sole issue of whether the directors, in exercising their business judgment not to maintain the requested action, acted with independence and in good faith. Defendants have now moved for summary judgment based on the "business judgment" rule.
The business judgment in question is not the decision made in 1974 to issue the options but, rather the decision made, after this action was commenced, to seek its dismissal. Of course, this latter decision rested in good part on the belief that the earlier actions were justified — a conclusion supported by the opinions of eminent, separate outside counsel retained by the company and the directors. (Each director was also told that he might obtain his own separate counsel if he wished.) But the decision of the directors was also based upon the obviously disastrous effect it would have upon employee morale to take away the newer options and return to them the older, worthless underwater options. These directors, in addition to not being personal beneficiaries of the options, were, in some instances, large stockholders of the corporation.
In theory, the business judgment rule in derivative actions looks only to the good faith of the directors in exercising their discretion not to maintain a lawsuit. It is virtually unavoidable, however, to measure the claimed good faith without some consideration of the merits of the proposed suit. If the directors were clearly correct in their opinion of the legal merits, the judgment not to bring the action is objectively supported. If their legal opinion was clearly unfounded, their decision is cast in a different light. For this reason, an examination of the facts giving rise to this actiot is helpful to the determination of the defendants' motion.
I
TRW had some form of a stock option plan for some years. Beginning in 1968, however, the price of TRW's common stock turned down and continued sliding through 1974. The decline in the market price resulted in options which were "underwater," and which could no longer perform their intended function as a financial inducement to attract and retain employees In 1973 the shareholders approved a stock option plan allowing the issuance and sale of 800,000 additional shares. Apparently only a couple of hundred thousand shares were granted at that time
In May, 1974, the stock option committee of TRW's board granted 551,928 new stock options to most of the employees who previously held options. Employees holding unexercised option under earlier plans were compelled to surrender them in order to obtain new options. (The committee had unexercised authority remaining under both the earlier stockholder-approved plans, but virtually all of the grants came from the 1973 plan.)
The price of the stock continued to decline. In October, 1974, the company granted 306,430 new options. These were issued under the 1967 plan and were available from 564,928 shares of old options surrendered in connection, with the May grant, as well as 8,370 unissued shares and 1,086 expired unexercised options. The full effect of the two 1974 grants was to substitute lower priced options for substantially all of the previously outstanding options.
Defendants argue that the two grants were intended to be totally new grants, not merely a modification of repricing of existing options as plaintiff contends. Plaintiff, however, argues that since the granting of the first lower priced options in May of 1974 was conditioned upon the grantee's surrender of all previously issued options, the entire transaction was intended merely to reprice the outstanding options, and that the granting of "new" options was only a gloss to cover the actual result. Defendants counter that the 1974 grants were in fact new options, granted under separate option agreements in which new "earn-out" periods were provided, and no tacking of earn-out periods under the surrendered options was permitted except under limited circumstances.
The underlying dispute thus hinges on whether the stock option committee lacked authority, as plaintiff contends, under the 1967 and 1973 plans, to amend or modify outstanding options by, in etfect, replacing them with options exercisable at lower prices. A subsumed issue is whether, the committee could legally attach the surrender condition to the granting of the new options.
Both the 1967 and 1973 plans specifically provided that the stock option committee
"may from time to time, and, upon such terms and conditions as it may determine, authorize the granting to officers (including officers who are Directors) and key employees of the Company or any of its subsidiaries of options to buy from the Company shares of its common stock and may fix the number of shares to be covered by each such option.
. . . .
"Each option shall contain such other terms and conditions not inconsistent herewith as shall be approved by the Stock Option Committee."
It is clear that the stock option committee under the terms of the existing plans, was authorized to grant new options, and could attach conditions to such options. There is no language in the plans which even suggests that one such condition could not be the surrender of the existing unexercised options. Moreover, it would be inconsistent with the terms of the plans to distribute options in an amount in excess of the number authorized, or to grant options at less than market value on the day of grant. Without passing on the merits of the controversy, it would appear to be within the committee's authority, when earlier options became worthless, to grant new options, with new earn-out periods, in order to restore the effectiveness of the option program. As to this aspect of the plaintiff's allegations, the board's decision to grant the new options appears quite sound.
Plaintiff also argues, however, that the authorized limits for the number of options allowable under the plans was exceeded by the 1974 grants. A simple arithmetic computation refutes this claim. Under the 1967 plan, as amended, TRW's shareholders had authorized the use of 700,000 shares for option grants to employees. Under the 1973 plan, an additional 800,000 shares had been duly authorized. It appears that in May 1974, there remained 564,660 shares which had not been issued under the 1973 plan. Accordingly, the stock option committee granted 551,928 new options at that time under the 1973 plan. While employees were required to surrender old options (if they held them) to receive the new ones, even without surrender, there were enough unissued options to cover the new issue and the company was left with a number of authorized, unissued options.
In the October, 1974 transaction, 306,430 new options were granted. As stated above, these options were granted under the 1967 plan, which had 596,151 available shares at the time, most of which (564,928 shares) became available because of the earlier surrender of old options in May of that year. Thus, as to the October, 1974 grants as well, the number of shares used for new options appears not to have exceeded the amount authorized by the shareholder-approved plan.
Defendants also argue that these computations are not even necessary, since the 1967 and 1973 plans authorized a limit only on the number of option shares actually "issued and sold," not on the number granted. Plaintiff asserts that such language would be interpreted by a shareholder to mean the number of shares which were authorized for grant. Without resolving this dispute, it is clear that what would be of primary concern to a shareholder would be the extent to which his equity interest might be diluted, and a shareholderapproved plan would be responsive to this concern by imposing a limit on the number of option shares "issued and sold." This consideration, therefore, would lend support to the defendants' interpretation.
The plaintiff alleges additionally a number of proxy violations. The alleged violations which are of any substance are premised on the contention that the granting of the 1974 options was unauthorized or illegal. In light of the foregoing analysis, which supports the defendants' claim that their actions were justified and reasonable with regard to the new option grants, a discussion of the alleged disclosure violations is unnecessary. It is sufficient to state that in light of the underlying merits of the plaintiff's allegations, a decision by a board of directors not to pursue such an action could be reasonable under objective standards.
II
The business judgment rule, of course, does not require a finding that the underlying claim posed by a shareholder-plaintiff is legally meritless. The rule embodies the traditional idea that the directors' decision whether to pursue a cause of action available to the corporation, like other business decisions, rests within the business judgment of the board. Absent a showing of fraud, collusion, selfinterest, bad faith, or breach of fiduciary duty, a board's refusal to sue should not be questioned by a court; consequently, a single shareholder's wish to supersede the board's judgment by pursuing a derivative action will not be allowed. See United Copper Securities Co. v. Amaigamated Copper Co., 244 U.S. 261, 263-b4 (1917); Harwes v. City of Oakland, 104 U.S. 450 (1881); Ash v. International Business Machines, Inc., 353 F.2d 491, 492-3 (3d Cir. 1965), cert. denied, 384 U.S. 927 (1966); In re Kauffman Mutual Fund Actions, 479 F.2d 257, 263 (1st Cir, 1973), cert. denied, 414 U.S. 857 (1973); Gall v. Exxon Corp., 418 F. Supp. 508 (S.D.N.Y. 1976); Bernstein v. Mediobanca Banca di Credito Funanziario-Societa per Azioni, 69 F.R.D.592 (S.D.N.Y. 1974);Klotz v. Consolidated Edison Co. of New York, 386 F. Supp. 577 (S.D.N.Y. 1974).
The only substantial argument raised by plaintiff in response to defendants' invocation of the business judgment rule is that, since the directors who made the decision not to press this action are themselves defendants in this case, there can be no good faith exercise of business judgment. This contention, however, does not survive reasonable analysis.
For example, the fact that directors are named as defendants has been held not to constitute a sufficient reason, in and of itself, to excuse a demand upon the board. Brooks v. American Export Industries Inc., 68 F.R.D. 506, 510 (S.D.N.Y. 1975); see Kauffman; 479 F.2d at 264. In the instant case six out of the fifteen directors disqualified themselves from the board's vote because they were option recipients. Thus, the inherent conflict of interest posed by their voting on the issue was avoided.
Of the remaining nine directors, three were members of the stock option committee directly charged with the alleged illegal option grants, and the remainder are charged with acquiescence, and implicit approval of the option grants. Allegations of this sort, however, where directors are chargedonly with participation and approval of the underlying transaction, without evidence of a real conflict, fraud or bad faith, has been held not to be a sufficient basis for excusing demand. Brooks v. American Export Industries, Inc., 68 F.R.D. at 511. in Kauffman, 479 F.2d at 265, the court stated:
"It does not follow . . . that a director who merely made an erroneous business judgment in connection with what was plainly a corporate act will `refuse to do [his] duty in behalf of the corporation if [he] were asked to do so.' Indeed, to excuse demand in these circumstances — majority of the board apnroval of an allegedly injurious corporate act- would lead to serious dilution of Rule 23.1."
Indeed, the business judzment rule would be meaningless if it were invalid any time the underlying transaction had been approved by the board, whose members were, as a consequence, named defendants. If that were the rule, any time board action was involved, simply by naming the company's directors as defendants, the business judgment rule would be rendered inoperable.
Plaintiff relies on Nussbacher v. The Chase Manhattan Bank, 444 F. Supp. — 973-(S.D.N.Y. 1977), in which defendants' summary judgment motion was granted, but the moving party's contention that the case be dismissed based on the business judgment rule was rejected. The court inNussbacher disallowed the business judgment defense on the grounds that the directors who approved of the transaction under attack could not be expected to exercise unbiased business judgment as to whether the action should be brought. Nussbacher. however, is distinguishable in that the bank's claim was based not on the business Judgment of its own directors, but rather a decision by the board of the company of which the plaintiff was a stockholder. Thus,Nussbacher presented an attempt by a third party to invoke the business judgment rule, a situation which might require greater scrutiny of the objective reasonableness of the business judgment.
In any event, it is clear that in the normal case simply joining all directors as named defendants should not invalidate per se the board's ability to exercise its collective judgment. See, e.g., Klotz v. Consolidated Edison Co., supra. If this were the rule, it would be a simple matter for one shareholder effectively to take over the management of the corporation as it relates to the proposed suit, even if the suit were patently against the corporation's interests. In this Court's view, in order to invalidate a board judgment, a greater showing of a real conflict of interest or bad faith is required.
In this connection, plaintiff's claim of bad faith is based on the admitted reliance of eight of the voting directors on a memorandum written by TRW's General Counsel, himself a recipient of options. Although the memorandum may have presented a conflict of interest with regard to the General Counsel personally that does not support a claim of bad faith by the directors. "The focus of the business judgment rule inquiry is on those who actually wield the decision-making authority . . .." Gall v. Exxon Corp., 418 F. Supp. at 517.
Beyond this, the plaintiff has not disputed the accuracy of any statement in the memorandum, which describes the facts of this case and fully recites the plaintiff's claims. Absent such evidence of misstatements, the possible conflict of the General Counsel cannot be found to have inteffered with the directors' good faith exercise of their discretion.
In addition, the directors' decision was supported by the independent opinion of a respected, independent law firm hired by board to investigate the merits of the underlying claim, and that firm's opinion was reconfirmed prior to the board's decision to seek dismissal of the suit.
Finally, at the board meeting and prior to the vote, the voting .directors listened to two more independent legal presentations, one from a firm representing the corporation, and one from a tirm representing the directors. Clearly, the voting directors took every precaution to insure that they received unbiased and fair advice in the matter, and their reliance on that advice dispels any claim of bad faith.
After extensive discovery, the piaintitf has been unable to establish any evidence controverting the conclusion that the directors' decision was anything but a careful good faith exercise of their business judgment. Accordingly, the defendants' motion for summary judgment is granted and the complaint is dismissed.