Kaplan v. Peat, Marwick, Mitchell & Co., 7124

• Decision Date: 23 January 1987
• Docket Number: No. 7124,7124
• Citation: 529 A.2d 254
• Parties: Bernard KAPLAN, Martin Fox and Warren Opal, trustees, on behalf of the Chase Manhattan Corporation, derivatively, Plaintiffs, v. PEAT, MARWICK, MITCHELL & CO., Defendant, and The Chase Manhattan Corporation, Nominal Defendant. Civ. A. . Submitted:
• Court: Court of Chancery of Delaware

Page 254

529 A.2d 254

Bernard KAPLAN, Martin Fox and Warren Opal, trustees, on behalf of the Chase Manhattan Corporation derivatively, Plaintiffs, v. PEAT, MARWICK, MITCHELL & CO., Defendant and The Chase Manhattan Corporation, Nominal Defendant.

Civ. A. No. 7124.

Court of Chancery of Delaware New Castle County.

Submitted: Jan. 23, 1987.

Decided: May 12, 1987.

Thomas G. Hughes and Mark D. Sisk, of Hughes and Sisk, Wilmington, Jerome M. Congress (argued), and Virginia A. LoPreto, of Milberg, Weiss, Bershad, Specthrie & Lerach, New York City, Carol A. Broderick, of Greenfield & Chimicles, Haverford, Pa., for plaintiffs.

Allen M. Terrell, Jr. and Kevin G. Abrams, of Richards, Layton & Finger, Wilmington, Victor M. Earle, III (argued), William T. Hegarty, and Allen S. Joslyn, of Cahill, Gordon & Reindel, New York City, for defendant Peat, Marwick, Mitchell & Co.

Robert K. Payson, of Potter Anderson & Corroon, Wilmington, for Chase Manhattan Corp.

OPINION

JACOBS, Vice-Chancellor.

This stockholder's derivative action was brought on behalf of The Chase Manhattan Corporation and its wholly-owned subsidiary, The Chase Manhattan Bank (collectively "Chase"), against Chase's former accountants, Peat, Marwick, Mitchell & Co. ("PMM"), for damages allegedly sustained as a result of financial dealings in which PMM had acted as Chase's independent auditor. The plaintiffs charge that PMM breached its duty of care and contractual duties owed to Chase by failing to conduct proper audits in the so-called "Drysdale" and "Penn Square" matters in which Chase became involved in 1982. PMM has moved to dismiss the action for failure to comply with Chancery Rule 23.1, and, alternatively, for summary judgment under Chancery Rule 56. This is the decision of the Court, following briefing and oral argument, on PMM's motion.

I. Relevant Facts

A. Background

The plaintiffs' complaint, as twice amended, alleges the following pertinent material: During 1981 and 1982, Chase purchased approximately $212.2 million of energy-related loans through Penn Square Bank ("Penn Square"), a small shopping center bank located in Oklahoma City, Oklahoma. (Second Amended Complaint ("Compl.") p 10). At that point Penn Square was in poor financial shape, and on or about July 5, 1982, federal banking authorities declared it insolvent. Id. As a result, Penn Square was closed and Chase was forced to charge off at least $45 million of loans that it had acquired through Penn Square. (Compl. p 11). PMM had conducted a special test of those loans for Chase. (Compl. p 12). It is alleged that at that time, PMM was also the auditor for Penn Square. Id.

Beginning in February 1982, Chase also entered into transactions with Drysdale Government Securities, Inc. ("Drysdale"), a government securities firm whose main activity was speculating in the purchase and sale of volatile securities and repurchase agreements. (Compl. pp 14, 15, 16). At that point Drysdale was in fact insolvent, but, nonetheless, had issued a statement disclosing a total subordinated debt and equity, as of February 1, 1982, of $20.8 million. (Compl. p 14). Chase received this statement sometime between February 1 and February 5, 1982. Thereafter Chase commenced doing business with Drysdale, including consummating repurchase and reverse repurchase agreements. (Compl. p 15). On May 17, 1982, Drysdale collapsed, owing Chase $270 million in coupon interest due on government securities transactions. Drysdale refused to pay that and other obligations it owed to Chase, and as a result, Chase allegedly suffered $285 million in damages. (Compl. p 18).

Plaintiffs claim that PMM knew or should have known of Chase's dealings with Drysdale, and that if PMM had conducted proper audits, it would have been able to alert Chase to Drysdale's straitened circumstances, thus enabling Chase to avoid the losses. (Compl. p 19). It is further charged that PMM, as auditor for both Chase and Penn Square, should have detected the deficiencies in the loans acquired by Chase through Penn Square. (Compl. p 20).

B. Facts Related to Demand

With respect to the making of a demand upon Chase's directors, the Second Amended Complaint alleges that:

5. On July 1, 1982, plaintiffs Fox and Opal demanded that the directors of Chase and the Bank institute suit against the officers and employees of the Bank and Chase responsible for the losses sustained by the Bank and Chase arising out of the purchase by the Bank of government securities under repurchase agreements to Drysdale Government Securities, Inc. ("Drysdale"). Upon information and belief, another shareholder of Chase made substantially similar demands, including demands that Chase and the Bank sue defendant Peat Marwick Mitchell & Co. ("Peat"), the former auditor of Chase and the Bank, which demands were rejected.

* * *

* * *

8. No demand has been made by plaintiff Kaplan upon the Company's directors to institute litigation or otherwise to seek recovery of its damages from Peat because such a demand would have been futile, as evidenced by the futility of those demands that were made.

The record on this point goes, however, beyond the complaint. In support of its motion for summary judgment, PMM submitted the affidavit of Michael E. Carlson, the Secretary of Chase (the "Carlson Affidavit"). In his affidavit, Mr. Carlson states that in a letter dated July 1, 1982, counsel for a Chase shareholder demanded that legal action be taken against those officers of Chase who were responsible for the Drysdale transactions, as well as against the Chase directors who were in office during that period. (Carlson Aff. p 3). At its July 21, 1982 meeting, Chase's Board of Directors created a Litigation Committee to conduct an independent and disinterested investigation to determine what response should be made to that demand. (Carlson Aff. p 4). The Litigation Committee consisted of three outside directors who were not in office during the Drysdale transactions. (Carlson Aff. pp 4, 8). On August 18, 1982, Chase's Board charged the Litigation Committee with the additional responsibility of investigating Chase's dealings with Penn Square. (Carlson Aff. p 7). Eventually the Litigation Committee recommended that Chase bring suit against six Chase officers to recover for the Penn Square loss, but that no suit be brought against Chase's directors. (Carlson Aff. p 25).

No demand was ever made upon Chase's Board, by plaintiffs or anyone else, to bring a lawsuit against PMM to recover for the Drysdale losses. (Carlson Aff. p 28). However, on August 20, 1982, a demand was made on behalf of a shareholder, Marjorie Janoff, that Chase institute immediate action against PMM for all losses incurred by Chase as a result of PMM's conduct with respect to the bankruptcy of Penn Square. (Carlson Aff. p 9). On August 27, 1982, Chase informed Ms. Janoff's counsel that her demand would be considered by the Board at its September 15, 1982 meeting. (Carlson Aff. p 11). On September 22, 1982, Chase informed Ms. Janoff's counsel that at that meeting, the Board had referred the matter to senior management to make a recommendation to Chase's audit committee. (Carlson Aff. p 12). Chase also advised counsel that a Litigation Committee had been created to determine whether Chase should pursue legal action against its directors and officers in connection with the Penn Square transactions. (Carlson Aff. p 13).

To assist it in investigating the Penn Square matters, Chase retained an independent accounting firm to review the work done by PMM. (Carlson Aff. pp 15, 16). After consultation with counsel (who had reviewed and considered the independent accountants' report), Chase's senior management recommended to Chase's audit committee that no litigation against PMM be pursued. (Carlson Aff. p 16). On February 18, 1983, Mr. Carlson wrote to counsel for Ms. Janoff, advising that:

Chase has carefully considered Ms. Janoff's demand in consultation with counsel and with Messrs. Deloitte, Haskins & Sells, accountants retained by counsel. On the basis of information currently available, Chase declines to sue Peat, Marwick, Mitchell & Co. since Chase believes it would not be in the best interest of the Corporation or its shareholders for such a suit to be commenced. However, Chase has instructed its counsel to continue monitoring developments relating to the complex Penn Square situation to ensure that the Chase rights are adequately protected and any claims are vigorously pursued.

(Carlson Aff. p 18).

In connection with the pending motion, Chase has submitted the affidavit of its Vice President and Director of Litigation, Mr. Kent T. Stauffer. The Stauffer affidavit (pertinently) states:

Chase neither objects to nor supports this action's being brought on Chase's behalf by certain of Chase's shareholders. Chase takes a neutral position on Peat Marwick's motion and leaves it to the decision of the Court.

(Stauffer Aff. p 3).

II. PMM's Motion to Dismiss on Demand Grounds

PMM urges that this action be dismissed on two independent, alternative grounds. First, PMM argues that the complaint is dismissible on its face because it fails to satisfy the requirements of Rule 23.1. Plaintiffs admit that they made no demand upon Chase to sue PMM in connection with the Penn Square and Drysdale matters. The complaint alleges, however, that a demand would have been futile because Chase's board had previously rejected a demand by another stockholder that PMM be sued. PMM contends that that allegation is legally insufficient to excuse a demand because plaintiffs have not alleged that the Board's rejection of that demand was wrongful.

PMM also contends, in the alternative, that it is entitled to summary judgment on the basis of the Carlson Affidavit which establishes, by facts extrinsic to the complaint, that (i) as to the Drysdale situation, no Chase stockholder (including the plaintiff) has ever made a demand upon Chase's Board to cause...