Indiana Law Review Notes The Business Judgment Rule and the Litigation Committee: The End of a Clear Trend in Corporate Law I. Introduction The time-honored business judgment rule has foiled many share- holder challenges to their directors' business decisions. 1 However, if self-dealing, bad faith, or lack of due care tainted the directors' deci- sion, the shareholder could summon the courts' aid. 2 A board's refusal to pursue a corporate cause of action historically would not block a shareholder's derivative suit naming a majority of the board as wrongdoers.3 Recently, however, corporations have persuaded federal courts to dismiss shareholder derivative actions if a commit- tee composed of ostensibly disinterested directors decides, in its good faith business judgment, to terminate the suit. 4 'The business judgment rule's origin coincided with the industrial growth of the latter portion of the nineteenth century. See Briggs v. Spaulding, 141 U.S. 132 (1891); Witters v. Sowles, 31 F. 1 (C.C.D. Vt. 1887); Spering's Appeal, 71 Pa. 11 (1872); Hodges v. New England Screw Co., 1 R.I. 312 (1850); Note, The Continuing Viability of the Business Judgment Rule as a Guide for Judicial Restraint, 35 Geo. Wash. L. Rev. 562, 565-66 (1967) (finding the rule parallel to the economic policy of laissez-faire). 2See United Copper Sec. Co. v. Amalgamated Copper Co., 244 U.S. 261 (1917); Galef v. Alexander, 615 F.2d 51 (2d Cir. 1980); Abbey v. Control Data Corp., 603 F.2d 724 (8th Cir. 1979), cert, denied, 444 U.S. 1017 (1980); Maher v. Zapata Corp., 490 F. Supp. 348 (S.D. Tex. 1980); Issner v. Aldrich, 254 F. Supp. 696 (D. Del. 1966); Gottlieb v. Heyden Chem. Corp., 90 A.2d 660 (Del. 1952); Guth v. Loft, 5 A.2d 503 (Del. 1939); Maldonado v. Flynn, 413 A.2d 1251 (Del. Ch. 1980). See also text accompanying notes 55-70 infra. 3United Copper Sec. Co. v. Amalgamated Copper Co., 244 U.S. 261, 264 (1917); Corbus v. Alaska Treadwell Gold Mining Co., 187 U.S. 455, 461 (1903); Hawes v. City of Oakland, 104 U.S. 450, 460 (1881); Galef v. Alexander, 615 F.2d 51, 61-62 (2d Cir. 1980); Ash v. International Bus. Mach., Inc., 353 F.2d 491, 493 (3d Cir. 1965), cert, denied, 384 U.S. 927 (1966); Swanson v. Traer, 249 F.2d 854, 858 (7th Cir. 1957); Nussbacher v. Chase Manhattan Bank, 444 F. Supp. 973, 977 (S.D.N.Y. 1977); Issner v. Aldrich, 254 F. Supp. 696, 701 (D. Del. 1966). 'Lewis v. Anderson, 615 F.2d 778 (9th Cir. 1979); Abbey v. Control Data Corp., 603 F.2d 724 (8th Cir. 1979), cert, denied, 444 U.S. 1017 (1980); Maldonado v. Flynn, 485 F. Supp. 274 (S.D.N.Y. 1980); Seigal v. Merrick, No. 74-2475 (S.D.N.Y. Dec. 20, 1979); Rosengarten v. International Tel. & Tel. Corp., 466 F. Supp. 817 (S.D.N.Y. 1979); Gall v. Exxon Corp., 418 F. Supp. 508 (S.D.N.Y. 1976); Auerbach v. Bennett, 47 N.Y.2d 619, 393 N.E.2d 994, 419 N.Y.S.2d 920 (1979); Parkoff v. General Tel. & Elec. Corp., 425 N.Y.S.2d 599 (App. Div. 1980); Falkenberg v. Baldwin, N.Y.L.J., Mar. 3, 1980, at 12, col. 6 (Sup. Ct. 1980); Wallenstein v. Warner, N.Y.L.J., May 9, 1978, at 11, col. 6 (Sup. Ct. 1978); Auerbach v. Aldrich, N.Y.L.J., Dec. 23, 1977, at 13, col. 5 (Sup. Ct. 1977); Levy v. Sterling Drug, Inc., N.Y.L.J., Nov. 23, 1977, at 10, col. 2 (Sup. Ct. 1977). Contra, Maher v. Zapata Corp., 490 F. Supp. 348 (S.D. Tex. 1980); Maldonado v. Flynn, 413 A.2d 1251 (Del. Ch. 1980). See also text accompanying notes 74-143 infra. 617 618 INDIANA LAW REVIEW [Vol. 14:617 This Note will review the traditional application of the business judgment rule as a defense for inexpedient business decisions and the rule's counterpart, the intrinsic fairness test.5 An examination of the "special litigation committee"6 cases will also be made, in light of the disparate results reached in three suits against Zapata Corpora- tion. 7 Finally, this Note will discuss the ramifications of the litiga- tion committee cases and the Zapata decisions. II. The Background of the Business Judgment Rule Corporation law places the management of corporate affairs under the direction of the board of directors.8 The courts recognized the necessity of an unfettered decision-making environment and developed the business judgment rule to effectuate the directors' exercise of discretion in management.9 Broadly stated, the business judgment rule provides that "the law will not hold directors liable for honest errors, for mistakes of judgment, when they act without corrupt motive and in good faith, that is, for mistakes which may properly be classified under the head of honest mistakes." 10 Some commentators perceive the business judgment rule to be incorporated into the statement of director duties posited by section 35 of the Model Business Corporation Act. 11 Section 35 provides: sSee text accompanying notes 55-70 infra. e Id. The committees are designated with various titles. For convenience, the general description "litigation committee" will be used. 'Maher v. Zapata Corp., 490 F. Supp. 348 (S.D. Tex. 1980); Maldonado v. Flynn, 485 F. Supp. 274 (S.D.N.Y. 1980); Maldonado v. Flynn, 413 A.2d 1251 (Del. Ch. 1980). Zapata is a Delaware corporation. "Del. Code Ann. tit. 8, § 141(a) (Supp. 1980); N.Y. Bus. Corp. Law § 701 (McKin- ney Supp. 1980-1981). See generally ABA-ALI Model Bus. Corp. Act Ann. 2d § 35 (Supp. 1977); N. Lattin, The Law of Corporations § 69 (2d ed. 1971). 'See, e.g., Galef v. Alexander, 615 F.2d 51, 57 (2d Cir. 1980); Cramer v. General Tel. & Elecs. Corp., 582 F.2d 259, 274 (3d Cir. 1978), cert, denied, 439 U.S. 1129 (1979); Auerbach v. Bennett, 47 N.Y.2d 619, 629, 393 N.E.2d 994, 1000, 419 N.Y.S.2d 920, 926 (1979); 3A W. FLETCHER, CYCLOPEDIA OF THE LAW OF PRIVATE CORPORATIONS, § 1039, at 37-38 (perm. ed. 1975); ABA, Corporate Director's Guidebook, 33 Bus. Law. 1595, 1604 (1978) [hereinafter cited as ABA]. 103A W. Fletcher, supra note 9, at 37; see H. Henn, Handbook of the Law of Corporations and Other Business Enterprises § 242, at 482 (2d ed. 1970); N. Lattin, supra note 8, § 78, at 272-73; ABA, supra note 9, at 1604; Note, The Continuing Viability of the Business Judgment Rule as a Guide for Judicial Restraint, 35 Geo. Wash. L. Rev. 562, 562-63 (1967); Comment, The Business Judgment Rule: A Guide to Corporate Directors' Liability, 7 St. LOUIS U.L.J. 151 (1962). "ABA, supra note 9, at 1632; Arsht, Fiduciary Responsibilites of Directors, Officers and Key Employees, 4 Del. J. Corp. L. 652, 662 (1979). See also Veasey, Directors' Standard of Care Under Section 35 of the Model Business Corporation Act, 4 Del. J. Corp. L. 665 (1979). 1981] BUSINESS JUDGMENT RULE 619 A director shall perform his duties as a director, including his duties as a member of any committee of the board upon which he may serve, in good faith, in a manner he reasonably believes to be in the best interests of the cor- poration, and with such care as an ordinarily prudent person in a like position would use under similar circumstances. 12 In other words, as long as the director remains within the bound- aries of conduct traced by the section 35 standard, the business judgment rule will be available as a defense to charges of liability for injuries sustained by the corporation and its shareholders. 13 In addition to exercising good faith and due care, a director must fulfill a fiduciary duty before he comes within the protection of the business judgment umbrella. 14 The Delaware Supreme Court pro- vided a universally recognized definition of that fiduciary duty in Guth v. Loft: 15 Corporate officers and directors are not permitted to use their position of trust and confidence to further their private interests. While technically not trustees, they stand in a fiduciary relation to the corporation and its stockholders. A public policy, existing through the years, and derived from a profound knowledge of human characteristics and motives, has established a rule that demands of a corporate officer or direc- tor, peremptorily and inexorably, the most scrupulous observ- ance of his duty, not only affirmatively to protect the interests l2ABA-ALI Model Bus. Corp. Act Ann. 2d § 35 (Supp. 1977). ,3ABA, supra note 9, at 1632; Arsht, supra note 11, at 660. "United Copper Sec. Co. v. Amalgamated Copper Co., 244 U.S. 261 (1917); Corbus v. Alaska Treadwell Gold Mining Co., 187 U.S. 455 (1903); Hawes v. City of Oakland, 104 U.S. 450 (1881); Galef v. Alexander, 615 F.2d 51 (2d Cir. 1980); Cramer v. General Tel. & Elecs. Corp., 582 F.2d 259 (3d Cir. 1978), cert, denied, 439 U.S. 1129 (1979); Ash v. International Bus. Mach., Inc., 353 F.2d 491 (3d Cir. 1965), cert, denied, 384 U.S. 927 (1966); Stadin v. Union Elec. Co., 309 F.2d 912 (8th Cir. 1962), cert, denied, 373 U.S. 915 (1963); Nussbacher v. Chase Manhattan Bank, 444 F. Supp. 973 (S.D.N.Y. 1977); Gall v. Exxon Corp., 418 F. Supp. 508 (S.D.N.Y. 1976); Bernstein v. Mediobanca Banca di Credito Finanziario-Societa Per Azioni, 69 F.R.D. 592 (S.D.N.Y. 1974); Klotz v. Con- solidated Ediscn Co., 386 F. Supp. 577 (S.D.N.Y. 1974); Sinclair Oil Corp. v. Levien, 280 A.2d 717 (Del. 1971); Getty Oil Co. v. Skelly Oil Co., 267 A.2d 883 (Del. 1970); Warshaw v. Calhoun, 221 A.2d 487 (Del. 1966); Gottlieb v. Heyden Chem. Corp., 90 A.2d 660 (Del. 1952); Bodell v. General Gas & Elec. Corp., 140 A. 264 (Del. 1927); Maldonado v. Flynn, 413 A.2d 1251 (Del. Ch. 1980). W. Fletcher, supra note 9, at 38; H. Henn, supra note 10, at 483; N. Lattin, supra note 8, § 78, at 272-73. See generally Guth v. Loft, 5 A.2d 503 (Del. 1939); Gottlieb v. McKee, 34 Del. Ch. 537, 107 A.2d 240 (1954); Lewis, The Business Judgment Rule and Corporate Directors' Liability for Mismanagement, 22 Baylor L. Rev. 157, 160-61 (1970). ,5 5 A.2d 503 (Del. 1939). 620 INDIANA LAW REVIEW [Vol. 14:617 of the corporation committed to his charge, but also to refrain from doing anything that would work injury to the corporation, or to deprive it of profit or advantage which his skill and ability might properly bring to it, or to enable it to make in the reasonable and lawful exercise of its powers. 16 Hence, "[bjusiness judgment . . . , by definition, presupposes an honest, unbiased judgment (compliance with fiduciary duty) reasonably exercised (due care), and compliance with other applic- able requirements." 17 As a defensive rule, the business judgment doctrine insulates the directors from personal liability unless the complaining shareholder is able to rebut the presumption that the directors have fulfilled all of their duties. 18 The business judgment rule has also been characterized as a standard for judicial review. 19 As a judicial guidepost, the "rule will be applied only when an objective evaluation of the context surrounding a decision indicates that forces influencing the judg- ment of the decision-makers uniformly tended to motivate a decision for the benefit of all shareholders." 20 However framed, the rule pro- vides directors with a sanctuary where they may exercise uninhibited corporate discretion unless self-dealing, bad faith, or lack of due care21 breach the rule's presidio.22 A. Public Policy Considerations The protection afforded by the business judgment rule is well supported by several policy arguments. First, the courts, especially 16M at 510. 17H. Henn, supra note 10, at 483. 18 See, e.g., Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971); Warshaw v. Calhoun, 221 A.2d 487, 493 (Del. 1966); ABA, supra note 9, at 1604. See generally cases cited note 2 supra; text accompanying notes 27-53 infra. "Note, The Continuing Viability of the Business Judgment Rule as a Guide for Judicial Restraint, 35 Geo. Wash. L. Rev. 562 (1967). 2 °Id. at 564. The author based his view on Judge Shientag's statement: "The 'business judgment rule' . . . yields to the rule of undivided loyalty." Bayer v. Beran, 49 N.Y.S.2d 2, 6 (Sup. Ct. 1944). 2, Although due care implies a negligence standard, the courts rarely hold direc- tors liable for mere negligence. See Bishop, Sitting Ducks and Decoy Ducks: New Trends in the Indemnification of Corporate Directors and Officers, 77 YALE L.J. 1078, 1099 (1968) ("The search for cases in which directors of industrial corporations have been held liable in derivative suits for negligence uncomplicated by self-dealing is a search for a very small number of needles in a very large haystack."). See, e.g., Selheimer v. Manganese Corp. of America, 423 Pa. 563, 224 A.2d 634 (1966). 22ABA, supra note 9, at 1604; Arsht, supra note 11, at 660; Lewis, supra note 14, at 172. See also text accompanying notes 27-53 infra. 1981] BUSINESS JUDGMENT RULE 621 when deluded by hindsight, are often "ill equipped" to pass judg- ment on complex business decisions.23 Second, imposition of liability for honest errors in judgment might stifle entrepreneurial risk- taking and chill board meetings.24 Third, the directors do not hold themselves out as insurers of the corporation's success; consequently, it would be unfair to impose liability upon directors for set-backs when the directors have fulfilled their duties to the corporation.25 Finally, state law puts the responsibility of management upon the board of directors elected by the shareholders and not upon a judicial system which is wholly unaccountable to the corporation and its shareholders. 26 To effectuate corporate goals, the corporate policy-making atmosphere must be free from judicial and shareholder interference. Shareholders, however, must be able to seek the courts' assistance when directors act in derogation of the best interests of the corporation and its shareholders. B. The Burden of Proof Most courts place upon the plaintiff-shareholder the burden of proving that a director's decision does not warrant the protection of the business judgment rule defense.27 In Ash v. International "Cramer v. General Tel. & Elecs. Corp., 582 F.2d 259, 274-75 (3d Cir. 1978), cert, denied, 439 U.S. 1129 (1979); Auerbach v. Bennett, 47 N.Y.2d 619, 629, 393 N.E.2d 994, 1000, 419 N.Y.S.2d 920, 926 (1979); ABA, supra note 9, at 1604; See Lewis, supra note 14, at 171-72. 24Cramer v. General Tel. & Elecs. Corp., 582 F.2d 259, 274 (3d Cir. 1978), cert, denied, 439 U.S. 1129 (1979); Bayer v. Beran, 49 N.Y.S.2d 2, 6 (Sup. Ct. 1944); ABA, supra note 9, at 1603-04; Dyson, The Director's Liability for Negligence, 40 Ind. L.J. 341, 367 (1965); Ward, Fiduciary Standards Applicable to Officers and Director's and the Business Judgment Rule Under Delaware Law, 3 Del. J. Corp. L. 244, 245 (1978); Note, supra note 1, at 565. 25See H. Henn, supra note 10, at 482-83; N. Lattin, supra note 8. 26Lewis, supra note 14, at 158, 171-72. See generally statutes cited note 8 supra. "United Copper Sec. Co. v. Amalgamated Copper Co., 244 U.S. 261 (1917); Cramer v. General Tel. & Elecs. Corp., 582 F.2d 259 (3d Cir. 1978), cert, denied, 439 U.S. 1129 (1979); Ash v. International Bus. Mach., Inc., 353 F.2d 491 (3d Cir. 1965), cert, denied, 384 U.S. 927 (1966); Gall v. Exxon Corp., 418 F. Supp. 508 (S.D.N.Y. 1976) Bernstein v. Mediobanca Banca di Credito Finanziario-Societa Pre Azioni, 69 F.R.D 592 (S.D.N.Y. 1974); Klotz v. Consolidated Edison Co., 386 F. Supp. 577 (S.D.N.Y. 1974) Sinclair Oil Corp. v. Levien, 280 A.2d 717 (Del. 1971); Getty Oil Co. v. Skelly Oil Co. 267 A.2d 883 (Del. 1970); Wolfensohn v. Madison Fund, Inc., 253 A.2d 72 (Del. 1969) Warshaw v. Calhoun, 221 A.2d 487 (Del. 1966); Marks v. Wolfson, 188 A.2d 680 (Del 1963); Bodell v. General Gas & Elec. Corp., 140 A. 264 (Del. 1927); Gimbel v. Signal Co. 316 A.2d 599 (Del. Ch. 1974); Puma v. Marriott, 283 A.2d 693 (Del. Ch. 1971); David J Greene & Co. v. Dunhill Int'l, Inc., 249 A.2d 427 (Del. Ch. 1968); Davis v. Louisville Gas & Elec. Co., 16 Del. Ch. 157, 142 A. 654 (1928). See Arsht, supra note 11, at 661-62; Lewis, supra note 14, at 172; Ward, supra note 24, at 245; Note, supra note 1, at 562. See generally ABA, supra note 9, at 1604. 622 INDIANA LAW REVIEW [Vol. 14:617 Business Machines, Inc., 28 the United States Court of Appeals for the Third Circuit held that [a] stockholder's derivative action . . . can be maintained only if the stockholder shall allege and prove that the direc- tors of the corporation are personally involved or interested in the alleged wrongdoing in a way calculated to impair their exercise of business judgment on behalf of the corporation, or that their refusal to sue reflects bad faith or breach of trust in some other way.29 The Delaware courts use such language as "fraud or gross over- reaching," 30 "bad faith or abuse of discretion," 31 "fraud, misconduct, or abuse of discretion," 32 "profited at the expense of the corporation," 33 and "improper motive ... or a reckless indifference to or a deliberate disregard of the stockholders" 34 to describe what the plaintiff must allege and show to overcome the business judg- ment defense. Finding this language overbroad,35 one commentator, after reviewing the Delaware decisions holding the business judg- ment rule inapplicable, found that the shareholder could circumvent the defense by showing: (1) that the directors did not exercise due care to ascertain the relevance of the available facts before voting to authorize the transaction; or (2) that the directors voted to authorize the transaction even though they could not have reasonably believed the transaction to be for the best interest of the corporation; or (3) that in some other way the directors' authorization of the transaction was not in good faith.36 Not surprisingly, these conditions encompass the directors' duties imposed by section 35 of the Model Business Corporation Act.37 28353 F.2d 491 (3d Cir. 1965). "Id. at 493. See also Corbus v. Alaska Treadwell Gold Mining Co., 187 U.S. 455 (1903); Klotz v. Consolidated Edison Co., 386 F. Supp. 577 (S.D.N.Y. 1974). "Sinclair Oil Corp. v. Levien, 280 A.2d 717, 722 (Del. 1971). 3, Warshaw v. Calhoun, 221 A.2d 487, 493 (Del. 1966). 32Kors v. Carey, 39 Del. Ch. 47, 54, 158 A.2d 136, 140 (1960). 33Maldonado v. Flynn, 413 A.2d 1251, 1256 (Del. Ch. 1980). See also Issner v. Aldrich, 254 F. Supp. 696, 700 (D. Del. 1966) ("helping themselves financially at the expense of the corporation"). 34Allaun v. Consolidated Oil Co., 16 Del. Ch. 318, 325, 147 A. 257, 261 (1929). 35Arsht, supra note 11, at 655. 36 Id. at 660. See also Lewis, supra note 14, at 172. 37Arsht argues that Delaware's business judgment rule is incorporated into sec- tion 35. Arsht, supra note 11, at 662. Arsht reasons that "the key issue is whether the directors, officers or controlling stockholders have complied with the legal standards 1981] BUSINESS JUDGMENT RULE 623 Exactly what facts the shareholder must bring forth to pierce the rule's shield is not always clearly articulated by the courts.38 Illustrative of the shareholder's predicament is the Delaware decision in Chasin v. Gluck. 39 Chasin involved a parent-subsidiary relationship in which the defendant, Gluck, by stock ownership, dominated the entire board of the parent, Grayson.40 Gluck used his position to con- trol eight 41 of the twelve directors of the subsidiary, Beck. 42 Beck rented space in Grayson stores in return for a percentage of Beck's sales. 43 The terms of the lease provided for Grayson employees to sell the Beck products, to commingle Beck receipts with Grayson receipts, and to remit Beck's portion of the receipts on a monthly basis. 44 Beck allowed Grayson's indebtedness to accumulate to $233,856.76 over eight months because of Grayson's financial diffi- culties. 45 After Grayson went into bankruptcy, shareholder Chasin brought a derivative suit claiming that the directors breached their fiduciary duty to Beck by not demanding timely debt payments when their dual capacities as directors in both firms should have given them knowledge of Grayson's precarious financial state.46 Defendant claimed that he merely used good business judgment to help Grayson through its financial trauma and thus secure Grayson's equity in Beck.47 Evidence showed that Gluck had personally guaranteed a $4,200,000 loan to the faltering Grayson company and had full knowledge of Grayson's financial crisis.48 Conceding that "Gluck could no doubt have hoped to be per- sonally benefited as a result of the transactions complained of through reduction of his personal liability on his guarantees of Grayson debts . . .," 49 the court found no direct evidence of Gluck's culpability despite his domination of both boards, his personal which the courts apply to determine whether directors have properly performed their duties. If they have met those standards, the court will not enjoin the transaction or hold them liabile." Id. at 660 (footnotes omitted). 38See Issner v. Aldrich, 254 F. Supp. 696 (D. Del. 1966); Findley v. Garrett, 109 Cal. App. 2d 166, 240 P.2d 421 (1952); Chasin v. Gluck, 282 A.2d 188 (Del. Ch. 1971). See generally text accompanying notes 39-53 infra. 39282 A.2d 188 (Del. Ch. 1971). i0 Id. at 189. ''Seven of the Beck directors were also Grayson directors. Id. ,2 Id. t3 Id. at 190. "Id. 4 7d. "Id. "Id. at 191. iS Id. i9 Id. at 192. 624 INDIANA LAW REVIEW [Vol. 14:617 knowledge of the financial problems, and his guarantee of Grayson loans. 50 The court held: [T]he mere fact that interlocking directors are involved in an intercorporate transaction does not of itself cause the higher burden of proof called for under such rule to shift to the party sought to be charged with accountability. In other words, self- dealing on the part of a dominant fiduciary must first be established in order for the intrinsic fairness rule to be suc- cessfully invoked . . . . 51 Not only did the court find the shareholder's evidence inadequate to show self-dealing,52 but the evidence was also deemed insufficient to show "bad faith, negligence, or gross abuse of discretion, the type of conduct looked for when a non-self-dealing fiduciary is sought to be charged with responsibility for corporate losses injurious to minority stockholders." 53 C. The Intrinsic Fairness Test If a shareholder's challenge survives the burden and pleading pitfalls 54 surrounding the business judgment rule defense, the counterpart of the business judgment rule, the intrinsic fairness test, may be invoked by the courts.55 This test is invoked because 50See text accompanying notes 40-41, 48 supra. 51282 A.2d at 192. %2 Id. at 193. 53 Id. 54The complaining shareholder not only must convince the court that the directors have breached their duties to the corporation and its shareholdes but also must pro- duce evidence sufficient to show active self-dealing, bad faith, or lack of due care. See text accompanying notes 27-53 supra. 55Teren v. Howard, 322 F.2d 949 (9th Cir. 1963) (stock options and waste) (deciding Delaware law); Harriman v. E.I. DuPont de Nemours & Co., 411 F. Supp. 133 (D. Del. 1975); Michelson v. Duncan, 407 A.2d 211 (Del. 1979) (stock option plan); Singer v. Magnavox Co., 380 A.2d 969 (Del. 1977); Sinclair Oil Corp. v. Levien, 280 A.2d 717 (Del. 1971); Getty Oil Co. v. Skelly Oil Co., 267 A.2d 883 (Del. 1970); Cheff v. Mathes, 199 A.2d 548 (Del. 1964) (perpetuation of control); Sterling v. Mayflower Hotel Corp., 93 A.2d 107 (Del. 1952); Gottlieb v. Heyden Chem. Corp., 90 A.2d 660 (Del. 1952) (stock option); Keenan v. Eshleman, 2 A.2d 904 (Del. 1938); Tanzer v. International Gen. In- dus., Inc., 402 A.2d 382 (Del. Ch. 1979); Schreiber v. Bryan, 396 A.2d 512 (Del. Ch. 1978); Kemp v. Angel, 381 A.2d 241 (Del. Ch. 1977); Palley v. McDonnell Co., 295 A.2d 762 (Del. Ch. 1972), aff'd sub nom. McDonnell Douglas Corp. v. Palley, 310 A.2d 635 (Del. 1973); Theodora Holding Corp. v. Henderson, 257 A.2d 398 (Del. Ch. 1969) (per- sonal loan); Bastian v. Bourns, Inc., 256 A.2d 680 (Del. Ch. 1969), aff'd, 278 A.2d 467 (Del. 1970); David J. Greene & Co. v. Dunhill Int'l, Inc., 249 A.2d 427 (Del. Ch. 1968); Porges v. Vadsco Sales Corp., 27 Del. Ch. 127, 32 A.2d 148 (1943). See generally Nathan & Shapiro, Legal Standard of Fairness of Merger Terms Under Delaware 1981] BUSINESS JUDGMENT RULE 625 "when the persons, be they stockholders or directors, who control the making of a transaction and the fixing of its terms, are on both sides, then the presumption and deference to sound business judg- ment are no longer present. Intrinsic fairness, tested by all relevant standards, is then the criterion." 56 As described in Chasin v. Gluck, 51 if the shareholder can show self-dealing, "bad faith, negligence, or gross abuse of discretion,"58 the burden of proof "shifts to the defendants to show the entire fairness of the transaction under the careful watch of the courts." 59 Most cases involving the intrinsic fairness test concern parent- subsidiary relationships such as mergers 60 or corporate opportur »,y. 61 Before scrutinizing the transaction, however, the courts require the shareholder to show the parent's domination and self-dealing. 62 Once these requirements are fulfilled, the directors may not avail themselves of the business judgment rule defense,63 and they must shoulder the burden of showing the entire fairness of the transaction. 64 The standard used to gauge the fairness of parent- subsidiary transactions requires "that the transaction between the two be reached as though each had in fact exerted its bargaining power against the other at arm's length."65 Of more interest are those cases involving stock option plans tainted by self-dealing. In Gottlieb v. Heyden Chemical Corp.,™ the Law, 2 Del. J. Corp. L. 44 (1977) (describing the business judgment rule and intrinsic fairness test as mutually exclusive extremes on a continuum). 56David J. Greene & Co. v. Dunhill Int'l, Inc., 249 A.2d 427, 430-31 (Del. Ch. 1968). See cases cited note 55 supra. "282 A.2d 188 (Del. Ch. 1971). 58M at 193. 59Schreiber v. Bryan. 396 A.2d 512, 519 (Del. Ch. 1978). m See, e.g., Roland Int'l Corp. v. Najjar, 407 A.2d 1032 (Del. 1979); Tanzer v. Inter- national Gen. Indus., Inc., 402 A.2d 382 (Del. Ch. 1979); Young v. Valhi, Inc., 382 A.2d 1372 (Del. Ch. 1978); Bastian v. Bourns, Inc., 256 A.2d 680 (Del. Ch. 1969), aff'd, 278 A.2d 467 (Del. 1970); Porges v. Vadsco Sales Corp., 27 Del. Ch. 127, 32 A.2d 148 (1943). 61 See, e.g., Sinclair Oil Corp. v. Levien, 280 A.2d 717 (Del. 1971); Getty Oil Co. v. Skelly Oil Co., 267 A.2d 883 (Del. 1970); Guth v. Loft, 5 A.2d 503 (Del. 1939); Gottlieb v. McKee, 34 Del. Ch. 537, 107 A.2d 240 (1954). 62Harriman v. E.I. DuPont de Nemours & Co., 411 F. Supp. 133, 152 (D. Del. 1975); Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971); Getty Oil Co. v. Skelly Oil Co., 267 A.2d 883, 887 (Del. 1970); Schreiber v. Bryan, 396 A.2d 512, 519 (Del. Ch. 1978); Chasin v. Gluck, 282 A.2d 188, 192 (Del. Ch. 1971); David J. Greene & Co. v. Dunhill Int'l, Inc., 249 A.2d 427, 430-31 (Del. Ch. 1968). 63David J. Greene & Co. v. Dunhill Int'l, Inc., 249 A.2d 427, 430-31 (Del. Ch. 1968). See generally cases cited note 62 supra. 64Schreiber v. Bryan, 396 A.2d 512, 519 (Del. Ch. 1978). See generally cases cited note 62 supra; Arsht, supra note 11, at 663; Ward, supra note 24, at 245. 65Getty Oil Co. v. Skelly Oil Co., 267 A.2d 883, 886 (Del. 1970). 6690 A.2d 660 (Del. 1952). 626 INDIANA LAW REVIEW [Vol. 14:617 directors instituted a stock option plan where "key employees" and the directors themselves received valuable options for no considera- tion. 67 The Delaware Chancery Court held that [w]here a majority of the directors representing the corpora- tion are conferring benefits upon themselves out of assets of the corporation, we do not understand that rule [business judgment rule] to have any application whatever. Human nature being what it is, the law, in its wisdom, does not presume that directors will be competent judges of the fair treatment of their company where fairness must be at their own personal expense. In such a situation the burden is upon the directors to prove not only that the transaction was in good faith, but also that its intrinsic fairness will withstand the most searching and objective analysis.68 The Gottlieb standard of fairness requires "the directors to prove that the bargain had in fact been at least as favorable to the cor- poration as they would have required if the deal had been made with strangers . . . ," 69 Thus, a situation involving self-dealing direc- tors strips away the business judgment defense and exposes the director to the harsher "stranger" standard of the intrinsic fairness test. 70 In summary, the business judgment rule is traditionally used as a defense to liability arising from mistakes in good faith business judgment which result in harm to the corporation and its share- holders. 71 The challenging shareholder must rebut the presumption that the directors have fulfilled all of their duties to the corporation and its shareholders before the courts will scrutinize the transac- tion. 72 Once the business judgment defense is circumvented, however, the directors have the burden of showing the entire fairness of the undertaking.73 6 7d. at 663. 68 /d. m Id. 70Cohen v. Ayers, 596 F.2d 733 (7th Cir. 1979); Teren v. Howard, 322 F.2d 949 (9th Cir. 1963); Michelson v. Duncan, 407 A.2d 211 (Del. 1979); Gottlieb v. Heyden Chem. Corp., 90 A.2d 660 (Del. 1952); Rosenthal v. Burry Biscuit Corp., 60 A.2d 106 (Del. 1948). See Galef v. Alexander, 615 F.2d 51 (2d Cir. 1980). Contra, Udoff v. Zipf, 58 A.D.2d 533, 395 N.Y.S.2d 462 (Sup. Ct. 1977). See generally Beard v. Elster, 160 A.2d 731 (Del. 1960); Kerbs v. California Eastern Airways, Inc., 32 Del. Ch. 219, 83 A.2d 473 (1951). nSee text accompanying notes 8-18 supra (this protection is available providing, of course, that the director has fulfilled all of his duties to the corporation and its shareholders); H. Henn, supra note 10, at 483. 12See cases cited note 27 supra; text accompanying notes 27-53 supra. nSee cases cited note 55 supra; text accompanying notes 55-70 supra. 1981] BUSINESS JUDGMENT RULE 627 III. The Litigation Committee A. The Committee Technique Since 1976, 74 shareholders have encountered an even more for- midable obstacle to their challenges of director impropriety than was presented by the traditional business judgment defense. Now when a shareholder brings a derivative action75 in a federal court,76 corporate directors are attempting to insulate themselves from per- sonal liability by appointing a "special litigation committee"77 osten- sibly composed of disinterested directors.78 The committee is empowered to determine, in its business judgment, whether the shareholder's derivative suit should proceed or be terminated. Federal courts have ruled that the business judgment rule removes the committee's determination from judicial interference and have dismissed the derivative actions unless the shareholders have been able to show that the committee lacked independence or conducted 74 Gall v. Exxon Corp., 418 F. Supp. 508 (S.D.N.Y. 1976). Gall seems to be the first federal decision involving the special litigation committee technique to insulate cor- porate directors from personal liability. 75A shareholder's derivative action is a suit brought by a shareholder on behalf of the corporation. The corporation, not the individual shareholder, owns the cause of action. The board of directors, hence, properly control the suit, as a corporate right. The derivative action allows a shareholder to assert a corporate claim "[w]hen the cor- porate cause of action is for some reason not asserted by the corporation itself . . . ." H. Henn, supra note 10, § 360, at 756. Justice Jackson described the derivative suit as "the chief regulator of corporate management." Cohen v. Beneficial Indus. Loan Corp., 337 U.S. 541, 548 (1949). See generally. Fed. R. Civ. P. 23.1; Note, The Demand and Standing Requirements in Stockholder Derivative Actions, 44 U. Chi. L. Rev. 168' (1976). '"Shareholders are taking derivative suits to federal courts for several reasons. Primarily, shareholders perceive state court as too permissive of director misconduct. See, e.g., Cary, Federalism and Corporate Law: Reflections Upon Delaware, 83 Yale L.J. 663, 666 (1974) (Delaware has "watered the rights of shareholders visa vis management down to a thin gruel."). The Federal Rules of Civil Procedure provide the shareholder with more amenable discovery and other procedural rules. Furthermore, federal judges are perceived as being more sophisticated in understanding business transactions and as being free from favoritism for state-based industries. See Jen- nings, Federalization of Corporation Law: Part Way or All the Way, 31 Bus. Law. 991, 998-1001 & n.47 (1976). "See cases cited note 4 supra. The directors find the authority to create executive committees in the articles of incorporation, by-laws, or state corporation law. Generally, a majority of the board must designate certain of its own members to the committee. The committee may, with certain exceptions, exercise all of the authority of the full board. See, e.g., ABA-ALI Model Bus. Corp. Act Ann. 2d § 42 (Supp. 1977). 78A disinterested director is a member of the board who is not "involved in a transaction with his own company where that transaction is designed to benefit that director personally . . . ." Moore, The "Interested" Director or Officer Transaction, 4 Del. J. CORP. L. 674, 674 (1979). Generally, the term "disinterested director" is used to 628 INDIANA LAW REVIEW [Vol. 14:617 its investigation in bad faith.79 This novel application of the business judgment rule has been seen as the harbinger of death for the shareholder derivative suit. 80 B. Stock Option Plans and Self-Dealing Although most of the independent investigation committee cases concern challenges of questionable payments made to foreign officials, 81 the cases involving self-dealing and stock option plans82 are of particular interest in light of the traditional disposition of such scenarios. 83 The decision of the United States Court of Appeals for the Ninth Circuit in Lewis v. Anderson™ provides a typical ap- plication of the business judgment rule to a litigation committee's refusal to sue. In 1973 Walt Disney Productions established a stock option incentive program for key employees.85 In the following year the board's stock option committee granted new options to its members and to other key employees.86 Two shareholders initiated a describe a director who is indifferent to the outcome of a committee's investigation into the conduct of fellow directors. See cases cited note 79 infra. But see Dent, The Power of Directors to Terminate Shareholder Litigation: The Death of the Derivative Suit?, 75 Nw. U.L. Rev. 96, 110-17 (1980) (contending that neither inside nor outside directors can be truly disinterested). 79See Lewis v. Anderson, 615 F.2d 778 (9th Cir. 1979); Abbey v. Control Data Corp., 603 F.2d 724, 729 (8th Cir. 1979), cert, denied, 444 U.S. 1017 (1980); Cramer v. General Tel. & Elecs. Corp., 582 F.2d 259, 275 (3d Cir. 1978), cert, denied, 439 U.S. 1129 (1979); Maldonado v. Flynn, 485 F. Supp. 274 (S.D.N.Y. 1980); Gall v. Exxon Corp., 418 F. Supp. 508, 516 (S.D.N.Y. 1976); Falkenberg v. Baldwin, N.Y.L.J., Mar. 3, 1980, at 12, col. 6 (Sup. Ct. 1980). But see Maldonado v. Flynn, 413 A.2d 1251, 1263 (Del. Ch. 1980) (dictum) (defendants have burden to show good faith and independence of com- mittee). 80Dent, The Power of Directors to Terminate Shareholder Litigation: The Death of the Derivative Suit?, 75 Nw. U.L. Rev. 96, 109 (1980). Dent referred to the litigation committee cases as "unjustifiable judicial legislation." Id. 81Abbey v. Control Data Corp., 603 F.2d 724 (8th Cir. 1979), cert, denied, 444 U.S. 1017 (1980); Cramer v. General Tel. & Elecs. Corp., 582 F.2d 259 (3d Cir. 1978), cert, denied, 439 U.S. 1129 (1979); Rosengarten v. International Tel. & Tel. Corp., 466 F. Supp. 817 (S.D.N.Y. 1979); Auerbach v. Bennett, 47 N.Y.2d 619, 393 N.E.2d 994, 419 N.Y.S.2d 920 (1979); Parkoff v. General Tel. & Elecs. Corp., 425 N.Y.S.2d 599 (App. Div. 1980); Wechsler v. Exxon Corp., 55 A.D.2d 875, 390 N.Y.S.2d 111 (1977); Falkenberg v. Baldwin, N.Y.L.J., Mar. 3, 1980, at 12, col. 6 (Sup. Ct. 1980); Auerbach v. Aldrich, N.Y.L.J., Dec. 23, 1977, at 13, col. 5 (Sup. Ct. 1977); Levy v. Sterling Drugs, Inc., N.Y.L.J., Nov. 23, 1977, at 10, col. 3 (Sup. Ct. 1977). 82Lewis v. Anderson, 615 F.2d 778 (9th Cir. 1979); Maher v. Zapata Corp., Fed. Sec. L. Rep. (CCH) 1 97,549 (S.D. Tex. May 27, 1980); Maldonado v. Flynn, 485 F. Supp. 274 (S.D.N.Y. 1980); Maldonado v. Flynn, 413 A.2d 1251 (Del. Ch. 1980). i3See notes 66-70 and accompanying text supra, 84 615 F.2d 778 (9th Cir. 1979) (interpreting California law). 9 7d. at 780. m Id. 1981] BUSINESS JUDGMENT RULE 629 derivative action claiming that the 1974 options were more favorable to the directors and, hence, violated federal securities law. 87 In response to the shareholders' challenge, the directors formed a special litigation committee composed of two outside directors and a named defendant-director who did not personally gain from the 1974 options. 88 The committee concluded that it was not in Disney's best interests to pursue the litigation, and the committee's counsel mov- ed for a summary judgment.89 The trial court granted counsel's mo- tion, holding that "if the committee exercised its business judgment in deciding to terminate the action, that decision could not be challenged derivatively . . . ." 90 Upholding the district court, the court of appeals in Lewis followed the two-step analysis previously prescribed by the United States Supreme Court in Burks v. Lasker. n The first inquiry was whether the relevant state law permitted a litigation committee to terminate a shareholder's derivative suit; the second inquiry asked whether such state law was consistent with relevant federal law.92 To answer the first inquiry, the Lewis court applied a synergistic argument to find California authority permitting committees to ter- minate shareholder derivative suits implicating a majority of the board.93 Although California law did not directly answer the first inquiry, the court found support for the application of the business judgment rule to the directors' good faith business decision to not pursue a cause of action.94 The shareholders claimed that the rule did not apply when a majority of the directors were named defend- ants in the suit.95 %1 Id. The directors used inside information that the Disney stock price was low and options granted at that price would be profitable. Id. at 783 n.2. m Id. at 780. m Id. 90 Id. (emphasis in original). 91 441 U.S. 471 (1979). Shareholders of an investment company alleged that the directors breached fiduciary duties under the Investment Company Act of 1940 and the Investment Advisor's Act of 1940 by purchasing $20 million jn Penn Central com- mercial paper from its investment advisor without independently investigating the paper's quality and safety. »2 Id. at 480. 93615 F.2d at 781-83. The Lewis court made its argument by citing some Califor- nia cases which involved the traditional application of the business judgment rule. The court based its extension of the business judgment rule to committee decisions on the federal decisions in Auerbach v. Bennett, 47 N.Y.2d 619, 393 N.E.2d 994, 419 N.Y.S.2d 920 (1979), and Abbey v. Control Data Corp., 603 F.2d 724 (8th Cir. 1979), cert, denied, 444 U.S. 1017 (1980), neither of which construed California law. 615 F.2d at 782-83. 94615 F.2d at 783. K Id. at 782. 630 INDIANA LAW REVIEW [Vol. 14:617 Citing Abbey v. Control Data Corp. 96 and Auerbach v. Bennett91 as reflecting a "clear trend in corporate law,"98 the Lewis court held "that the good faith exercise of business judgment by a special litigation committee of disinterested directors is immune to attack by shareholders or the courts." 99 The decision was supported by the court's notation that the independent committee, not the defendants, 100 invoked the business judgment rule to protect its refusal to sue. 101 Furthermore, policy considerations were held to favor the decision: To allow one shareholder to incapacitate an entire board of directors merely by leveling changes against them gives too much leverage to dissident shareholders. There is no reason to believe that a minority shareholder is more likely to act in the best interest of the corporation than are directors who are elected by a majority of the stockholders.102 The Lewis opinion recognized that a court could probe the independence of the committee and examine its investigative pro- cedures. 103 "The business judgment rule, as we interpret it, would not bar a derivative action when a special litigation committee of disinterested directors dismisses an action in bad faith." 104 The court skirted the independence issue by merely noting "that the indepen- dent committee members were appointed by interested directors is an 'inescapable' aspect of 'the corporation's predicament.'" 105 The Lewis court merely conceded that this situation "presents problems." 106 Finding that California law authorized a committee dismissal of a shareholder's derivative suit, the Lewis court tersely found this interpretation of state law consistent with the policies underlying federal securities laws. 107 Thus, the second inquiry mandated by 96 603 F.2d 724 (8th Cir. 1979), cert, denied, 444 U.S. 1017 (1980). 97 47 N.Y.2d 619. 393 N.E.2d 994, 419 N.Y.S.2d 920 (1979). 98615 F.2d at 783. "Id. ""The court was apparently not concerned that one member of the committee was named as a defendant. Id. at 782. m Id. at 783. 10 7d. m Id. * 0i Id. The court did not clearly articulate, however, who must show the committee's lack of independence or good faith. See note 79 and accompanying text supra. ]05 Id. See also Auerbach v. Bennett, 47 N.Y.2d 619, 633-34, 393 N.E.2d 994, 1002, 419 N.Y.S.2d 920, 928 (1979). ,06615 F.2d at 783. m Id. at 783-84. 1981] BUSINESS JUDGMENT RULE 631 Burks v. Lasker, 108 whether the state law is consistent with the rele- vant federal laws, was answered affirmatively by the Lewis court. 109 IV. The Zapata Decisions Another stock option plan modification scenario triggered a trio of actions against the Zapata Corporation. 110 These three cases may mark the end of the "clear trend in corporate law" 111 that allows director-appointed litigation committees to terminate shareholder derivative suits under the purported auspices of the business judg- ment rule when a majority of the board are accused of misconduct. 112 First, the New York District Court decision 113 will be reviewed as a further extension of the Lewis trend. This discussion will be followed by a study of the impact on shareholders engendered by the litiga- tion committee cases. Next, the precipitous end to the litigation committee trend portended by the subsequent resolutions of the com- panion Zapata actions 114 will be examined. Finally, arguments for the future application of the business judgment rule will be presented. A. The Zapata Factual Background All three actions share the same factual background. In 1971 the Zapata board devised a stock option program under which directors and key officers could exercise options to buy Zapata common stock at $12.15 per share in five installments ending July 14, 1974. 115 Immediately prior to July 14, 1974, Zapata planned to annouce a tender offer for 2,300,000 of its own shares. 116 The announcement was predicted to raise the market price per share from $18 to about $25. 117 Realizing that significant additional federal income tax liability would be incurred by a post-announcement option exercise,118 the 108 441 U.S. at 480. 109 615 F.2d at 783-84. 110Maher v. Zapata Corp., 490 F. Supp. 348 (S.D. Tex. 1980); Maldonado v. Flynn, 485 F. Supp. 274 (S.D.N.Y. 1980); Maldonado v. Flynn, 413 A.2d 1251 (Del. Ch. 1980) (decided Mar. 18, 1980). Zapata is a Delaware corporation. All three claims stem from the same misconduct, self-dealing and a stock option plan. '"Lewis v. Anderson, 615 F.2d 778, 783 (9th Cir. 1979). llzSee cases cited note 4 supra. 113Maldonado v. Flynn, 485 F. Supp. 274 (S.D.N.Y. 1980). 114Maher v. Zapata Corp., 490 F. Supp. 348 (S.D. Tex. 1980); Maldonado v. Flynn, 413 A.2d 1251 (Del. Ch. 1980). 115Maldonado v. Flynn, 413 A.2d 1251, 1254 (Del. Ch. 1980). ni Id. ne Id. The capital gain incurred after the tender offer announcement would be equal to the difference between $25 per share, the market price after the announce- ment, and $12.15 per share, the exercise price. If the directors exercised their options 632 INDIANA LAW REVIEW [Vol. 14:617 director-optionees accelerated 119 the exercise date to July 2, 1974 to avoid the capital gain consequences of a post-announcement exer- cise. 120 The directors exercised their options on July 2, 1974 and obtained a suspension in trading of Zapata shares until the an- nouncement date. 121 The tender offer was made on July 8, 1974, and the market price per share immediately rose to $24.50. 122 Thus, the directors avoided personal income tax liability at the expense of Zapata's federal tax deduction for the same amount. 123 In 1975 the shareholders filed the three actions against Zapata. Four years later, the directors created an "Independent Investi- gative Committee" composed of two newly appointed outside direc- tors. 124 The committee was empowered to investigate the three claims and to dispose of them in a manner consistent with the com- mittee's business judgment.125 After a three month investigation, the committee determined that none of the three shareholder derivative suits were in Zapata's best interests and moved for a dismissal of all pending claims. 128 In support of its decision, the com- mittee mustered the following twelve reasons: (1) the asserted claims appeared to be without merit; (2) costs of litigation, exacerbated by likelihood of indemnifica- tion; (3) wasted senior management time and talents on pur- suing litigation; (4) damage to company from publicity; (5) that no material injury appeared to have been done to com- pany; (6) impairment of current director-defendants' ability at the market price of $18 per share prevailing before the announcement, the capital gain would be reduced to the difference between $18 per share and the exercise price of $12.15 per share. In other words, the directors could reduce their taxable capital gain by $7 per share, a 54% reduction. " 9 /d. The directors moved up the date upon or after which the options could be exercised from July 14, 1974 to July 2, 1974. This ploy enabled the directors to avoid the market's reaction to Zapata's tender offer. 120413 A.2d at 1254. This scenario is similar to that in Lewis where the directors took advantage of inside information to formulate a stock opinion grant. See note 87 supra. ,2, 413 A.2d at 1254-55. m Id. at 1255. ' 23 Id. Zapata could have offset its federal tax liability by an additional amount equal to the difference between the per share prices of $24.50 and $18.00 had the direc- tors exercised their options on the original exercise date after the tender offer announcement. m Id. Both of the committee members were appointed to fill vacancies in the board. The committee was formed under the corporation's bylaws and Delaware law. See Del. Code Ann. tit. 8, § 141(c) (1974) ("such committee . . . may exercise all the powers and authority of the board of directors in the management of the business and affairs of the corporation . . . ."). 125413 A.2d at 1255. ,2 7rf. 1981] BUSINESS JUDGMENT RULE 633 to manage; (7) the slight possibility of recurrence of viola- tions; (8) lack of personal benefit to current director- defendants from alleged conduct; (9) that certain alleged practices were continuing business practices, intended to be in company's best interests; (10) legal question whether the complaints stated a cause of action; (11) fear of undermining employee morale; (12) adverse effects on the company's rela- tions with employees and suppliers and customers.127 B. The Clear Trend Continues in New York The first disposition of the three Zapata challenges, Maldonado v. Flynn, 128 was decided on January 25, 1980 by the United States District Court for the Southern District of New York. The New York derivative suit alleged that the directors' failure to disclose in election proxy materials their self-interest in the stock option plan modification violated section 14(a) 129 of the Securities and Exchange Act of 1934. 13° The shareholder sought to nullify the election of the directors stemming from the illegal proxy solicitations. 131 In responding to the shareholder's allegations, the New York court adhered to the two step approach of Burks v. Lasker132 to decide whether an investigative committee of two disinterested directors could terminate a derivative suit which named all nine fellow directors as defendants under Delaware law. 133 Noting that Delaware courts had not addressed this issue, the New York court cited the opinion of the United States Court of Appeals for the Eighth Circuit in Abbey v. Control Data Corp. 13* as conclusively establishing that Delaware law would apply the business judgment rule to an investigative committee's refusal to sue when a majority of the board were defendants in a suit. 135 The Abbey court relied on '"Maldonado v. Flynn, 485 F. Supp. 274, 284 n.35 (S.D.N.Y. 1980). See Maher v. Zapata Corp., 490 F. Supp. 348, 350-51 (S.D. Tex. 1980). ,28 485 F. Supp. 274 (S.D.N.Y. 1980). 129 Securities Exchange Act of 1934, § 14(a), 15 U.S.C. § 78n(a) (1976). Section 14(a) was promulgated to "protect investors from promiscuous solicitation of their proxies, on the one hand, by irresponsible outsiders seeking to wrest control of a corporation away from honest and conscientious corporation officials; and on the other hand, by unscrupulous corporate officials seeking to retain control of the management by con- cealing and distorting facts." S. Rep. No. 1455, 73d Cong., 2d Sess. 77 (1934). See also Orrick, The Revised Proxy Rules of the Securities and Exchange Commission, 11 Bus. Law. 32 (1956). ,30Maldonado v. Flynn, 485 F. Supp. at 278. m Id. 132 441 U.S. 471, 480 (1979). 133 485 F. Supp. at 278. Eleven directors constituted Zapata's board. 134 603 F.2d 724, 729 (8th Cir. 1979), cert, denied, 444 U.S. 1017 (1980). 135485 F. Supp. at 278. 634 INDIANA LAW REVIEW [Vol. 14:617 the Delaware cases of Puma v. Marriott 136 and Beard v. Elster131 for its pronouncement. The Maldonado court cited Beard for the pro- position that a court may not substitute its "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 fur- therance of the corporate enterprise." 138 Relying on Puma, the New York court found the business judgment rule to apply "even where some board members are disqualified from participating in the board's decision . . . ." 139 Finding the power to direct litigation within the director's realm, 140 the New York court concluded: Thus under Delaware law a committee of disinterested direc- tors, 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. 141 In a footnote, 142 the court referred to the "clear trend in corporate law" recently recognized in Lewis v. Anderson 1 *3 to further buttress the court's holding. The second inquiry mandated by Burks 144 is whether the court's interpretation of Delaware's business judgment rule is consistent with section 14(a) of the Securities and Exchange Act of 1934. 145 Con- tending that the purpose of section 14(a) is to prevent management 136283 A.2d 693, 695-96 (Del. Ch. 1971). The New York court also noted that section 144(a) of the Delaware General Corporation Law allows interested director transac- tions if approved by an informed vote of a majority of the disinterested directors. Del. Code Ann. tit. 8 § 144(a) (Supp. 1978). ,37 160 A.2d 731, 738-39 (Del. 1960). 138485 F. Supp. at 279 (quoting Beard v. Elster, 160 A.2d 731, 738-39 (Del. I960)). ,39 485 F. Supp. at 279. ],0 Id. The court quoted United Copper Sec. Co. v. Amalgamated Copper Co.: 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 direc- tors are guilty of misconduct equivalent to a breach of trust, or where they stand in a dual relationship which prevents an unprejudiced exercise of judg- ment. 244 U.S. 261, 263-64 (1917). 141 485 F. Supp. at 279-80. m JtL at 280 n.16. ,43615 F.2d 778 (9th Cir. 1979). '"441 U.S. at 480. '"Securities Exchange Act of 1934, § 14(a), 15 U.S.C. § 78n(a) (1976). 1981] BUSINESS JUDGMENT RULE 635 from obtaining authority for corporate action through deceptive proxy materials, 146 the shareholder claimed that allowing "the very violators of the statute to control exercise of this right of action renders federal law meaningless." 147 The New York court concluded that section 14(a) and the business judgment rule were consistent by citing similar rulings in Abbey v. Control Data Corp. 148 and Burks v. Lasker. U9 The Maldonado court also noted that although derivative suits could be terminated by the board, the business judgment rule did not totally preclude enforcement of section 14(a) claims. A shareholder could always bring an individual action or a class action on behalf of all shareholders. 150 C. The Impact of the Litigation Committee Cases The litigation committee cases demonstrate the erosion of a shareholder's ability to derivatively protect the corporation and its shareholders from the ravages of director malversation. Allowing a board to interpose an "independent" committee's decision to not pursue the derivative action, thereby compelling dismissal of a derivative suit, leaves the shareholder uncertain of the substantive effect of the business judgment rule and of his ability to redress injuries to the corporation and its shareholders. The most devastating impact on the shareholder results from the allocation of the burden of proof dictated by the litigation com- mittee cases. Under the conventional application of the business judgment rule as a director's defense, the burden fell on the shareholder to impugn the rule's shield by showing fraud, self- dealing, bad faith, or lack of due care. 151 Once the shareholder made an adequate showing of impropriety or nonfulfillment of duties, the burden shifted to the director-defendant to exhibit the entire fairness of the transaction under the court's careful scrutiny. 152 Now, however, with the bastardized application of the business judgment rule, the burden falls on the shareholder to rebut the independence or good faith of the litigation committee even though a majority of 146See also note 13 supra. 147485 F. Supp. at 281. 148 603 F.2d 724, 731-32 (8th Cir. 1979), cert, denied, 444 U.S. 1017 (1980). 149 441 U.S. at 485 (finding Investment Company Act and Investment Advisors Act consistent with state law permitting independent directors to terminate a nonfrivolous derivative suit). 150 485 F. Supp. at 281. The court did not consider the expense and burden such alternatives would place on the shareholder. See generally Fed. R. Civ. P. 23(c)(2). 151See text accompanying notes 30-37 supra. 152See text accompanying notes 55-70 supra. 636 INDIANA LAW REVIEW [Vol. 14:617 the board are accused of wrongdoing or suffer dismissal of the derivative suit. 153 Showing the committee's nonindependence is an onerous task 154 for the shareholder, especially when the courts find only actual par- ticipation in the tainted transaction sufficient to defeat the rule's protection of the committee's decision. 155 The New York action, Maldonado v. Flynn, 156 crystallizes the frustrations confronted by a shareholder challenging a committee's independence. In Maldonado the shareholder attacked the committee's independence on three grounds. First, one committee member was a partner in the law firm employed by the corporation. 157 Second, one member was appointed to the board on the day the committee was formed, thereby implying that the member was appointed for the sole purpose of favorable committee membership. 158 Third, the entire committee membership was selected by the defendants. 159 Referring to these claims as "vigorous innuendo," 160 the court stated that "the fact that the Committee's membership became directors by appointment does not itself indicate that they bore any special loyalty to the disqualified directors or that they were any less effectively divorced from dependence upon the board then [sic] would have been the case with elected directors." 161 The opinion also noted that the committee members "owe the same fiduciary duty as any director to the corporation and its shareholders." 162 A shareholder's frustration with attempting to reveal the com- mittee's lack of independence is exacerbated by the common-sense awareness of the many inherent pressures on directors to be interested. An inside director's decision not to sue a fellow director 153See cases cited note 79 supra. ]b,See Boyko v. Reserve Fund, Inc., 68 F.R.D. 692, 696 (S.D.N.Y. 1975) (excusing demand on ostensibly disinterested board because "tangible indications of bias on the part of the unaffiliated majority are rarely present"); Johnston v. Greene, 121 A.2d 919 (Del. 1956) (difficulty of showing bad faith). 166 See, e.g., Lewis v. Anderson, 615 F.2d 778, 780 (9th Cir. 1979) (court did not impugn committee's independence even though one member was a named defendant who had not gained from the transaction); Maldonado v. Flynn, 485 F. Supp. at 283 (committee found independent despite one member's partnership in law firm hired as committee's counsel). I56485 F. Supp. 274 (S.D.N.Y. 1980). ,5 7d. at 283. 159 /d. This situation was usually present in all of the litigation committee cases. Most courts only went as far as noting that this problem is inescapable. See Lewis v. Anderson, 615 F.2d 778 (9th Cir. 1979); Auerbach v. Bennett, 47 N.Y.2d 619, 393 N.E.2d 994. 419 N.Y.S.2d 920 (1979). ,,,0485 F. Supp. at 284. ""ta at 283-84. "7d at 283. 1981] BUSINESS JUDGMENT RULE 637 may be influenced by salary, promotion, fringe benefits, employee morale, and career considerations. 163 Outside directors are subject to conflicts arising from personal friendships, pressures to conform, gratitude for position, and responsibilities to other corporations. 164 By forcing the shareholder to challenge the independence of the litigation committee and by requiring more than a showing of in- herent pressures in order to avoid dismissal under the business judgment rule, the courts have effectively pronounced the last rites for the shareholder's derivative suit. 165 The litigation committee cases compound the shareholders' miseries by clouding the substantive meaning of the business judg- ment rule. Following the traditional use of the defense, the court in Gottlieb v. Heyden Chemical Corp. 166 clearly made the business judg- ment defense unavailable if a majority of the corporation's directors were accused of self-dealing. 167 Similarly, the United States Supreme Court in Hawes v. Oakland™ gave shareholders the right to bring a derivative suit when "the board of directors, or a majority of them, are acting for their own interest, in a manner destructive of the cor- poration itself, or of the rights of the other shareholders." 169 Now, even though a majority of the board may be defendants, the litiga- tion committee cases allow the committee of directors to erect the business judgment rule defense and to compel dismissal of a shareholder's derivative action. 170 Chief Judge Cooke of the New York Court of Appeals commented in his dissenting opinion to Auer- bach v. Bennett 111 that the application of the business judgment rule to a litigation committee decision to terminate a shareholder derivative suit naming a majority of the directors placed the shareholder in a "'Catch-22'" 172 position. He also observed that the "result reached by the majority not only effectively dilutes the substantive rule of law at issue, but may also render corporate directors largely unaccountable to che shareholders whose business they are elected to govern." 173 ,63See Dent, supra note 80, at 111, 113. m Id. at 111-13. See also Coffee, Beyond the Shut-Eyed Sentry: Toward a Theoretical View of Corporate Misconduct and an Effective Legal Response, 63 Va. L. Rev. 1099, 1233-34 (1977). 195See Dent, supra note 80, at 109. 16690 A.2d 660 (Del. 1952). l67 /d. at 663. See also cases cited note 70 supra. ,68 104 U.S. 450 (1881). 16 7d. at 460. ""See cases cited note 4 supra; text accompanying notes 84-143 supra. 17, 47 N.Y.2d 619, 393 N.E.2d 994, 419 N.Y.S.2d 920 (1979) (dissenting opinion). "2 Id. at 619, 393 N.E.2d at 1004, 419 N.Y.S.2d at 931. m Id. 638 INDIANA LAW REVIEW [Vol. 14:617 The subsequent Zapata decisions may mark the return of the traditional application of the business judgment rule and an end to the "clear trend in corporate law" 174 that permits a committee of disinterested directors to compel dismissal of a shareholder's derivative suit in which a corporate board has been implicated. 175 D. The Clear Trend Fades in Delaware On March 18, 1980, nearly two months after the New York case ended, 176 the Delaware Chancery Court rendered its decision in Maldonado v. Flynn. 111 In state court the shareholder alleged that Zapata's directors breached their fiduciary duty to the corporation and its shareholders by depriving Zapata of a federal tax deduction in an amount equal to the reduction in capital gain achieved by the optionees who exercised their options on the accelerated exercise date. 178 The defendant-directors contended that the business judg- ment rule permitted a disinterested committee to compel dismissal of a derivative suit determined to be contrary to the corporation's best interests. 179 They further asserted that the burden of proof should fall on the shareholder to dispel the presumption of the com- mittee's independence and good faith. 180 The Delaware court denied Zapata's motion for dismissal 181 after a thorough analysis of the business judgment rule and the history of the derivative suit. 182 Beginning with a review of Delaware's applica- tion of the business judgment rule, the court's analysis revealed that [i]ts character as a purely defensive rule has never been seriously challenged. The rule, however, is not of universal application, nor without exception. It does not irrevocably shield all corporate transactions .... It requires utmost loyalty to the corporation and its interests and does not pro- tect fraudulent, illegal, or reckless decisions by the directors .... And, of course, the rule has no application where there is a showing that the directors have profited at the expense of the corporation. 183 '"Lewis v. Anderson, 615 F.2d at 783. nsSee cases cited note 4 supra. 176Maldonado v. Flynn, 485 F. Supp. 274 (S.D.N.Y. 1980). m 413 A.2d 1251 (Del. Ch. 1980). ,78413 A.2d at 1255. m I