Director Liability: How Indiana's Business Judgment Rule Protects Directors From Shareholder Derivative Lawsuits
In 1986, the Indiana General Assembly, in response to a series of disturbing decisions in other jurisdictions, notably Delaware, boldly adopted a strong pro-director corporate statute. Not only did it materially limit the circumstances in which directors may be held personally liable for their actions to shareholders, it also undertook steps that were designed to mitigate the cost of litigation. Two significant examples of this attitude were the adoption of “conclusive presumptions” in favor of decisions by disinterested directors with respect to corporate actions and with respect to the termination of derivative lawsuits brought by shareholders. It also moved away from a negligence standard for personal liability of directors and passed the requirement that a director must have acted willfully or recklessly to be personally liable. It is against this backdrop that the Indiana Supreme Court recently considered a certified question from the United States District Court, Southern District of New York.
In the ITT Corporation derivative litigation case, two ITT shareholders filed a lawsuit on behalf of ITT against ITT’s directors in federal court in New York. The shareholders alleged that the directors violated fiduciary duties owed to ITT by failing to monitor and supervise the management of an ITT business unit named Night Vision. In 2007, ITT pled guilty and entered into a deferred prosecution agreement as a result of Night Vision’s alleged export of military technology to countries in violation of the U.S. State Department’s restrictions prohibiting the exportation of technical data. ITT agreed to pay fines and penalties of $50 million and invest another $50 million in developing night vision systems for the U.S. military. The shareholders’ derivative action sought to hold all of ITT’s directors personally liable to reimburse the corporation for these costs.
A derivative action is a lawsuit asserted by a shareholder on the corporation’s behalf against a third party because of the corporation’s failure to take some action against the third party. Derivative actions are typically brought to recover for a lost corporate opportunity, recover corporate waste, and recover damages to a corporation caused by a director’s self-dealing. Before a shareholder can file a derivation action, the shareholder must first demand that the corporation’s board of directors act to pursue the right or remedy unless demand of the board is excused, such as being a futile act.
One ITT shareholder demanded the board to act, the other did not. The court dismissed the claims of the shareholder who failed to make a demand. In response to the other’s demand, the board formed a “special litigation committee” of disinterested directors to investigate the claims. This committee determined that the corporation should not pursue the claims. The federal trial court in New York asked the Indiana Supreme Court what standard should apply in determining whether a director is “disinterested” within the meaning of Indiana’s special litigation committee rules, since ITT is an Indiana corporation subject to Indiana law. In other words, the federal trial court wanted to know if the special litigation committee’s decision stood in the way of the derivative action.
The Indiana Supreme Court answered and held that to determine whether a director is “disinterested,” the trial court needs to determine whether the derivative claim poses a “significant risk” or “substantial likelihood” of personal liability to the director. Because of the absence of Indiana case law on point, the Indiana Supreme Court began its analysis examining Delaware case law involving alleged breaches of fiduciary duties. Under Delaware law, directors are personally liable for failing to monitor corporate employees when: (a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention. That is, under Delaware law, director liability requires a showing of a conscious decision by directors to breach their duty of care and a showing of bad faith. Indiana law, however, has even higher protections afforded to actions by directors than Delaware law.
Under Indiana law, directors are protected from personal liability unless they engage in willful or reckless misconduct. Typically, the business judgment rule holds that directors are not liable for informed decisions taken in good faith and in the exercise of honest judgment in the lawful and legitimate furtherance of corporate purposes. This rule presumes that in making business decisions, the directors acted on an informed basis, in good faith, and in honest belief that the action taken was in the best interests of the corporation. By statute, a shareholder challenging a director’s actions under Indiana law has to show that the director engaged in reckless or willful misconduct to overcome this presumption. This very high standard reflects the Indiana legislature’s intent to narrow the bases for director liability in response to an increasing number of lawsuits against directors, the increasing expense of defending such claims, and the increasing cost of director and officer liability insurance. Furthermore, Indiana law reflects a strong preference that directors and not shareholders control corporate rights, which allows corporations to operate efficiently and allows directors to exercise control over corporate activities.
Thereafter, the Indiana Supreme Court politely suggested that the federal trial court in New York reexamine its determination that the outside directors on the ITT special litigation committee were disinterested. In other words, the Indiana Supreme Court implied that it would have determined that the special litigation committee directors were disinterested and dismissed the ITT shareholders’ claims outright after the special litigation committee’s decision not to pursue the claims was reached.
From the perspective of a lawyer who advises corporate boards regarding their oversight responsibilities, five takeaways from the ITT Derivative Litigation case include:
- Corporations are creatures of state law and even if a corporation is a global, multi-industry corporation like ITT, so long as it is incorporated in Indiana, it is the Indiana Business Corporation Law that sets its corporate governance rules.
- The Indiana Supreme Court takes seriously the policy of the Indiana General Assembly, as embodied in the Indiana Business Corporation Law, favoring the actions of disinterested directors.
- Courts in other jurisdictions must be educated that the Indiana Business Corporation Law is not the same as Delaware law or any other state’s corporate law.
- There is a mechanism by which courts unfamiliar with the Indiana corporate governance rules can certify to the Indiana Supreme Court particular issues.
- The fact that there is a policy favoring leaving the management of Indiana corporations in the hands of the directors instead of the shareholders does not mean that corporate directors should assume they will be given a pass if they do not fulfill their duties.
From the perspective of a lawyer who advises corporate boards in litigation, five takeaways from the ITT case include:
- Take shareholder demands seriously. Communicate with the shareholder to determine what rights or remedies the shareholder believes the corporation should pursue and see if the concerns can be alleviated without the burden, expense, and distraction of litigation.
- Consider using a special litigation committee. Have the board assemble a special litigation committee of disinterested directors to determine whether and to what extent it is in the corporation’s best interests to pursue any legal rights or remedies it may have.
- Make sure the directors participating in the special litigation committee are “disinterested,” as defined under state law. In Indiana, this includes examining whether the directors have a “substantial likelihood” of personal liability over any decision they make. If the directors are not disinterested, the entire process of utilizing a special litigation committee may be wasted.
- If a shareholder files a derivative claim without first making a demand of the board to act, move to dismiss the claim as premature. If the shareholder claims that demand would be futile, make the shareholder prove why a demand would be futile. A conclusory statement that demand would be futile is not enough, and courts will often grant an early dismissal of the shareholder’s derivative claim based on unsupported conclusions rather than facts.
- Use the presumption afforded to the decision of the special litigation committee to move for summary judgment to terminate the shareholder’s derivative action as quickly and efficiently as possible. A determination by a special litigation committee consisting of disinterested directors is presumed to be correct and cannot be second-guessed by shareholders or a judge or jury.
Indiana’s Business Corporation Law is strongly pro-director and shareholders who disagree with the business decisions of directors can voice their displeasure by electing new directors or selling their shares.
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