Maldonado v. Flynn

• Decision Date: 24 January 1980
• Docket Number: No. 77 Civ. 3180.,77 Civ. 3180.
• Citation: 485 F. Supp. 274
• Parties: William MALDONADO, Plaintiff, v. William H. FLYNN, Sam Israel, Jr., A. G. Gueymard, J. B. Harrison, Ronald C. Lassiter, B. J. Mackin, Michael R. Naess, Eugene F. Shiels, Robert B. Wall and Zapata Corporation, Defendants.
• Court: U.S. District Court — Southern District of New York

485 F. Supp. 274

William MALDONADO, Plaintiff, v. William H. FLYNN, Sam Israel, Jr., A. G. Gueymard, J. B. Harrison, Ronald C. Lassiter, B. J. Mackin, Michael R. Naess, Eugene F. Shiels, Robert B. Wall and Zapata Corporation, Defendants.

No. 77 Civ. 3180.

United States District Court, S. D. New York.

January 24, 1980.

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Garwin & Bronzaft, New York City, for plaintiff; Sidney L. Garwin, New York City, of counsel.

George A. Burrell, P.C., New York City, for defendant Zapata Corp.

Rogers & Wells, New York City, for individual defendants.

OPINION

EDWARD WEINFELD, District Judge.

This is a stockholder's derivative suit on behalf of Zapata Corporation ("Zapata"), a Delaware corporation, against nine of its past and present directors. Initially, claims were asserted under sections 10(b), 14(a) and 7 of the Securities Exchange Act (the "1934 Act") and the rules thereunder, and under the common law. All were based upon a modification in 1974 of Zapata's stock option plan by its board of directors. This Court dismissed the complaint for failure to state a cause of action.¹ The Court of Appeals affirmed except as to plaintiff's claim that the proxy materials used to secure the election of directors in 1975, 1976 and 1977 were false and misleading in not disclosing the circumstances surrounding the plan's modification. This was held to state a claim under section 14(a) and the case was remanded for further proceedings.²

Plaintiff subsequently filed an amended complaint, again reciting the circumstances of the plan's modification but alleging only a single cause of action for the violations of section 14(a) pleaded in the original complaint with respect to the 1975 through 1977 elections, and in addition for similar violations in proxy statements issued by Zapata in late 1977 and in 1978 for the election of directors. The amended complaint seeks to nullify the elections of directors from 1975-1979; an injunction against further misleading proxy statements; and to recover from the defendants on behalf of Zapata damages allegedly flowing from the issuance of the claimed deceptive proxy materials.

Zapata moves to dismiss the amended complaint pursuant to Rule 12(b)(6) or alternatively for summary judgment pursuant to Rule 56 of the Federal Rules of Civil Procedure. Its motion is based upon a business judgment determination by the Independent Investigation Committee of Zapata Corporation (the "Committee") that continuation of this action is contrary to the best interests of the corporation on whose behalf it was brought and that it therefore should not be pursued further.

The Committee, with a membership of two disinterested directors, was created by a resolution of Zapata's board of directors dated June 25, 1979.³ They are not defendants in this action; they were designated long after it had been commenced; they had no involvement in matters that are the subject of the action. The Committee was charged with reviewing several derivative actions then pending against certain of the corporation's directors. In its "Report and Determination" dated September 21, 1979, the Committee reported on its investigation of three lawsuits—this one included⁴—and its conclusion, inter alia, that this action was not in Zapata's best interests. It directed the corporation's counsel to move to dismiss the action.

Plaintiff, in opposing the motion, urges that the "business judgment rule" of Delaware is inconsistent with section 14(a) of the Securities Act of 1934 and cannot be used to foreclose prosecution of his claim thereunder. Thus at issue is the applicability of the business judgment rule to a pending derivative action alleging a section 14(a) violation, when a specially appointed committee of disinterested directors, after a thorough investigation, recommends dismissal of the action as not in the best interests of the corporation. Guidance to the answer is given by the Supreme Court in the recently decided case of Burks v. Lasker (hereafter "Burks").⁵ Addressing this very question with respect to a suit under the Investment Company Act⁶ and the Investment Advisers Act,⁷ Burks held that a two-step inquiry was required: As a threshold question, does applicable state law permit independent directors to terminate a derivative action against other board members? And, if so, is such a state law rule consistent with the policies of the federal laws upon which the action is based?⁸

While the Delaware courts⁹ have yet to address the precise issue of whether Delaware corporation law permits a derivative action against some of a corporation's directors to be terminated by disinterested, independent directors empowered to act for the corporation, the Court of Appeals for the Eighth Circuit, in Abbey v. Control Data Corp.¹⁰ (hereafter "Abbey"), proceeding through the same two-step analysis undertaken here, examined relevant Delaware law and concluded that it did. This Court agrees with that conclusion.

As the Abbey opinion notes, it is Delaware's law that business decisions by a disinterested board of directors are insulated from shareholder challenge and judicial scrutiny. Of this highly deferential "business judgment rule" Delaware's Supreme Court has written:¹¹

We think the fact that a disinterested Board of Directors reached this decision by the exercise of its business judgment is entitled to the utmost consideration by the courts in passing upon the results of that decision. Such has long been the law of this State.

. . . . .

We are precluded from substituting our uninformed opinion for that of experienced business managers of a corporation who have no personal interest in the outcome and whose sole interest is the furtherance of the corporate enterprise.

Moreover, even where some board members are disqualified from participating in the board's decision, actions taken by independent, disinterested directors in the exercise of their independent business judgment will also be sustained.¹²

The business judgment rule is applicable to decisions regarding litigation brought on the corporation's behalf. Again as noted by the Eighth Circuit, this application of the rule is a longstanding feature of corporate law.¹³ It has found expression in federal jurisprudence in United Copper Securities Co. v. Amalgamated Copper Co.,¹⁴ where, discussing the demand requirement in derivative suits, Justice Brandeis wrote:

Whether or not a corporation shall seek to enforce in the courts a cause of action for damages is, like other business questions, ordinarily a matter of internal management 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.

Consonant with this generally accepted view, Delaware's Supreme Court has held that the power to conduct a corporation's litigation is part of the undisputed power of the board to manage the corporation's business.¹⁵ Thus under Delaware law a committee of disinterested directors, properly vested with the power of the board, may in the exercise of their business judgment require the termination of a derivative suit brought on the corporation's behalf even though other directors are disqualified from participating in such a decision because they are named as defendants in the suit.¹⁶

We turn to the second leg of the inquiry mandated by Burks, whether this rule is inconsistent with the policies underlying section 14(a) of the 1934 Act, the law upon which this action is based. The weight of existing authority supports a conclusion that there is no such inconsistency. Before the Supreme Court decided Burks, several lower federal courts had ordered the dismissal of derivative actions brought under section 14(a) upon the motion of independent directors, relying upon acceptance of the business judgment rule in earlier federal cases.¹⁷ Had there been any clearly apparent inconsistency between this application of the rule and the policies of the federal statute, it is a reasonable assumption that some reference would have been made to it. In fact, in Abbey v. Control Data Corp.,¹⁸ the District Court was urged to adopt a rule that public policy underlying the 1934 Act precluded application of the business judgment rule. The court rejected this position and noted that there was no authority to support it.

The Burks decision itself provides significant, affirmative support for a finding that the application of the business judgment rule does not contravene the purpose of the 1934 Act. Since the lower courts had not considered any state law, the Supreme Court was not in a position to decide whether any given state law rule about director termination of lawsuits was consistent with the Investment Company Act or the Investment Advisers Act; however, it took strong issue with the Second Circuit's view that no rule—state or federal—permitting independent directors to terminate an action would be consistent with the federal statutes.¹⁹ The Court remarked:

There may well be situations in which the independent directors could reasonably believe that the best interests of the shareholders call for a decision not to sue—as, for example, where the costs of litigation to the corporation outweigh any potential recovery. In such cases, it would certainly be consistent with the Act to allow the independent directors to terminate a suit, even though not frivolous.²⁰

It went on to hold "that Congress did not require that States, or federal courts, absolutely forbid director termination of all nonfrivolous actions."²¹

Finally, the two Courts of Appeals which to date have actually applied the Burks analysis to suits alleging section 14(a) violations and have addressed the...