SYLLABUS
(This syllabus is not part of the opinion of the Court. It has
been prepared by the Office of the Clerk for the convenience of the
reader. It has been neither reviewed nor approved by the Supreme Court. Please
note that, in the interests of brevity, portions of any opinion may not
have been summarized).
Argued February 26, 2002 -- Decided July 23, 2002
Verniero, J., writing for a unanimous Court.
In this appeal, the Court considers the proper standard of review to
be applied in evaluating whether a corporation's board of directors responded properly in
rejecting a shareholder's demand to commence legal action on the corporation's behalf, and
whether the lower court correctly applied that standard in this case.
This appeal stems from four derivative actions brought by shareholders of Public
Service Enterprise Group, Incorporation (Enterprise), a public utility holding company, and its wholly-owned
subsidiary, Public Service Electric & Gas Company (PSE&G)(collectively, the company). Defendants are certain
directors of both entities and include current and former PSE&G officers (collectively, the
Board). PSE&G operates the Salem and Hope Creek nuclear power plants (power plants)
located in southern New Jersey. Based on events that took place over a
period of many years, plaintiffs allege that defendants recklessly mismanaged both power plants
to the company's financial detriment.
On October 4, 1995, following the closing of one of the power plants,
plaintiff G.E. Stricklin sent a formal demand letter to the Board asking it
to institute suit against each of its officers for mismanagement of the nuclear
operations. In response, the Board adopted a resolution on October 17, 1995, retaining
the law firm of Kasowitz, Benson,Torres & Friedman (the Kasowitz firm) to investigate
the allegations raised in the demand letter. On December 27, 1995, before the
Kasowitz firm's investigation was complete, Stricklin filed a shareholder derivative complaint that raised
the same allegations as the demand letter and contended that Board members should
be held personally liable for the company's financial losses. Stricklin also contended that
her demand on the Board had been rejected wrongfully because the Board had
not acted on it. On February 28 and March 5, 1996, additional shareholders
filed two more derivative actions, but they did not make a demand on
the company prior to instituting suit. Instead, they assert that such demand would
have been futile.
Meanwhile, the Kasowitz firm reviewed over 43,000 pages of documents and conducted over
thirty interviews with company personnel. After completing its investigation, the firm issued a
124-page report on February 8, 1996, and a supplemental report on March 14,
1996, concluding that there was no basis on which to institute legal action
against any employee, officer, or director of Enterprise or PSE&G. On March 19,
1996, the Board adopted a resolution accepting the Kasowitz firm's recommendations. Later, in
depositions or certifications, the Board members gave their reasons for rejecting the litigation,
including 1) the memorandum and reports presented by counsel; 2) the inquisitiveness and
preparedness of Board members at meetings during the relevant time period; 3) the
open lines of communication and information in respect of the company's nuclear operations;
4) the depth of the information presented to the Board on a regular
basis and its vigorous action in response to that information; and 5) the
excessive cost of such litigation.
On July 3, 1996, a fourth shareholder filed a complaint. The trial
court consolidated the four actions and defendants moved to dismiss the complaints. In
December 1996, the trial court found that all four plaintiffs had alleged sufficient
facts to withstand dismissal. The trial court further excused the failure to make
a demand by some of the plaintiffs because it found that they had
alleged sufficient facts to create a reasonable doubt that the directors were disinterested
or independent. The Appellate Division and this Court denied leave to appeal.
After the consolidated cases were transferred to another judge, the cases were
bifurcated according to whether a demand had been made by the plaintiffs (demand-made
cases), or whether a demand had not been made by the plaintiffs (demand-futile
cases). Defendants moved for summary judgment in the demand-made cases in December 1997
and in the demand-futile actions in May 1998. In deciding the motions, the
judge adopted a modified version of the business judgment rule and ordered discovery
on issues that included the disinterestedness of the Board and the reasonableness of
its decision to terminate litigation. The trial court granted defendants' motions for summary
judgment at the conclusion of discovery. The Appellate Division affirmed.
HELD : The Court adopts the modified business judgment rule as the standard for
evaluating whether a corporation's board of directors responded properly in rejecting a shareholder's
demand or in deciding to terminate legal action on the corporation's behalf. The
modified business judgment rule places an initial burden on directors to demonstrate that
they acted reasonably, in good faith, and in a disinterested fashion in arriving
at their decision. The lower courts properly applied that standard when dismissing the
derivative litigation in this case.
1. A shareholder derivative action permits a shareholder to bring suit on behalf
of the corporation and, if successful, it forces the wrongdoers to compensate the
corporation for the injury they caused. Shareholder derivative litigation is an infringement on
director autonomy and may have a negative effect on corporate governance if, for
example, it is initiated by opportunistic shareholders. Therefore, as a prerequisite to derivative
litigation, most jurisdictions require that shareholders make a demand on the corporation's board
of directors to act. New Jersey's procedure is codified under Rule 4:32-5. Like
most jurisdictions, New Jersey will excuse the demand requirement if the shareholder can
establish that it would be futile. For shareholder plaintiffs in New Jersey to
withstand a motion to dismiss for failure to make a demand, they must
plead with particularity facts creating a reasonable doubt that: 1) the directors are
disinterested and independent; or 2) the challenged transaction was the product of a
valid exercise of business judgment. (Pp. 18 to 29).
2. The Court agrees with those jurisdictions that apply a single standard of
review in both demand-made case and in cases in which the demand was
excused, and adopts a modified business judgment rule that imposes an initial burden
on a corporation to demonstrate that in deciding to reject or terminate a
shareholder's suit the members of the board 1) were independent and disinterested; 2)
acted in good faith and with due care in their investigation of the
shareholder's allegations, and that 3) the board's decision was reasonable. Shareholders must be
permitted access to corporate documents and other discovery limited to the narrow issue
of what steps the directors took to inform themselves of the shareholder demand
and the reasonableness of their decision. (Pp. 29 to 33).
3. The main difference between the test for determining demand-futility and the modified
business judgment rule is that a plaintiff has the burden of demonstrating demand-futility,
whereas a defendant has the burden of satisfying the elements of the modified
business judgment rule. If the court relieves a shareholder of the demand requirement,
a defendant may later renew its motion to dismiss the litigation. At that
juncture, the court would evaluate the motion by applying the burden-shifting and other
aspects of the modified business judgment rule. Although the demand-futility test and the
modified business judgment rule both implicate whether directors are disinterested and independent, a
court applying the modified business judgment rule is not bound by any finding
associated with an earlier court's decision to excuse demand. The court should consider
the board's decision under the modified business judgment rule only after the parties
have completed adequate discovery to enable the court to render a fully-informed decision.
(Pp. 33 to 37).
4. The thrust of plaintiffs' allegations is that defendants mismanaged the company and
breached their duty of care. The Court reserves for another day what the
appropriate standard might be for allegations such as self-dealing, fraud, or similar bad
acts. (Pp. 37 to 38).
5. The Court finds that defendants presented undisputed evidence proving that they were
disinterested and independent when they decided to reject the demand and terminate the
litigation. Moreover, nothing in the record demonstrated that the directors had divided loyalties,
stood to receive any improper personal gain or were unduly influenced by any
improper motive. Therefore, defendants satisfied the first element of the modified business judgment
rule. (Pp. 38 to 41).
6. The second element of the modified business judgment rule, whether defendants acted
in good faith and with due care in investigating the merits of the
litigation, was met through the extensive investigation and resulting report by the Kasowitz
firm, which was experienced in nuclear power matters and in shareholder litigation. (Pp.
41 to 46).
7. Finally, defendants satisfied the final element of the test by demonstrating that
their decision to terminate the litigation was reasonable. By virtue of the procedures
that they employed, defendants informed themselves of the substance of the shareholders' allegations
and weighed those allegations against the likelihood that the litigation would succeed. The
Board acted consistent with the principles articulated in the Court's opinion when relying
on the Kasowitz investigation to guide its decision. (Pp. 47 to 51).
The judgment of the Appellate Division is AFFIRMED.
JUSTICE STEIN, concurring in the Court's opinion, agrees that the Board satisfied
the legal standard for independence in this matter, but emphasizes that the de
novo review undertaken by trial and appellate courts should include a scrupulous and
painstaking examination of the record to ensure that the board's discretion has been
exercised reasonably and responsibly. Further, Justice Stein is of the view that the
Kasowitz firm's dual role as the Board's independent investigator and its brief role
as the Board's litigation counsel was inappropriate, but he believes that the dual
role did not render unreasonable the Board's reliance on the investigative report.
CHIEF JUSTICE PORITZ and JUSTICES COLEMAN, LONG, and LaVECCHIA join in JUSTICE VERNIERO's
opinion. JUSTICE STEIN filed a separate concurring opinion. JUSTICE ZAZZALI did not participate.
SUPREME COURT OF NEW JERSEY
A-41/
42 September Term 2001
IN RE: PSE&G SHAREHOLDER
LITIGATION
DR. STEVEN FINK AND DR. DAVID FRIEDMAN, P.C. PROFIT SHARING PLAN, derivatively on
behalf of and for the benefit of Public Service Enterprise Group, Incorporated and
Public Service Electric & Gas Company,
Plaintiffs-Appellants,
v.
LAWRENCE R. CODEY; E. JAMES FERLAND; LEON R. ELIASON; STEVEN E. MILTENBERGER; JOSEPH
J. HAGAN; AND STANLEY LaBRUNA,
Defendants-Respondents,
and
PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED and PUBLIC SERVICE ELECTRIC & GAS COMPANY,
Nominal Defendants-Respondents.
A. HAROLD DATZ PENSION AND
PROFIT SHARING PLAN
Plaintiff-Appellant,
and
GAIL DORFF, derivatively on behalf of and for the benefit of Public Service
Enterprise Group, Incorporated and Public Service Electric & Gas Company,
Plaintiff,
v.
LAWRENCE R. CODEY; E. JAMES FERLAND; LEON R. ELIASON; STEVEN E. MILTENBERGER; JOSEPH
J. HAGAN; and STANLEY LaBRUNA,
Defendants-Respondents,
and
PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED and PUBLIC SERVICE ELECTRIC & GAS COMPANY,
Nominal Defendants-Respondents.
PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED BY G. E. STRICKLIN derivatively in her capacity
as a shareholder,
Plaintiff-Appellant,
v.
E. JAMES FERLAND; IRWIN LERNER; MARILYN M. PFALTZ; RICHARD J. SWIFT; LAWRENCE R.
CODEY; ERNEST H. DREW; JAMES C. PITNEY; T. J. DERMOT DUNPHY; RAYMOND V.
GILMARTIN; JOSH S. WESTON and STEVEN E. MILTENBERGER,
Defendants-Respondents,
and
SHIRLEY A. JACKSON,
Defendant,
and
PUBLIC SERVICE ENTERPRISE GROUP INCORPORATED,
Nominal Defendant- Respondent.
Argued February 26, 2002 – Decided July 23, 2002
On certification to the Superior Court, Appellate Division.
Ruthann Gordon, a member of the Pennsylviana bar, argued the cause for appellants
Dr. Steven Fink and Dr. David Friedman, P.C. Profit Sharing Plan and A.
Harold Datz Pension and Profit Sharing Plan (Cohn Lifland Pearlman Herrmann & Knopf,
attorneys; Ms. Gordon and Peter S. Pearlman, on the briefs).
Mark C. Rifkin, a member of the Pennsylviana and New Jersey bars, argued
the cause for appellant G. E. Stricklin (Sherman, Silverstein, Kohl, Rose & Podolsky,
attorneys; Mr. Rifkin and Alan C. Milstein, on the briefs).
Harold G. Levison argued the cause for respondents Lawrence R. Codey, E. James
Ferland, Irwin Lerner, Marilyn M. Pfaltz, Richard J. Swift, Ernest H. Drew, James
C. Pitney, T. J. Dermot Dunphy, Raymond V. Gilmartin, Josh S. Weston; and
Michael R. Griffinger argued the cause for respondents Steven E. Miltenberger, Leon R.
Eliason, Joseph J. Hagan and Stanley LaBruna
(Kasowitz, Benson, Torres & Friedman and Zazzali, Fagella & Nowak, attorneys for
Lawrence R. Codey and E. James Ferland;
Connell, Foley & Geiser and William E. Frese, attorneys for Public Service Enterprise
Group Incorporated and Public Service Electric & Gas Company; (Gibbons, Del Deo, Dolan,
Griffinger & Vecchione attorneys for Leon R. Eliason, Steven E. Miltenberger, Joseph J.
Hagan and Stanley LaBruna; Mr. Levison, Mr. Griffinger, Mr. Frese, Kenneth I. Nowak
and Kevin R. Gardner, on the briefs).
Jason S. Feinstein submitted a letter in lieu of brief on behalf of
amicus curiae, New Jersey Chamber of Commerce (Sterns & Weinroth, attorneys).
The opinion of the Court was delivered by
VERNIERO, J.
We are called on to address certain questions of first impression regarding the
law of business organizations in New Jersey. The principal issue concerns the proper
standard of review to be applied when evaluating whether a corporation’s board of
directors has responded properly in rejecting a shareholder’s demand to commence legal action
on the corporation’s behalf. We hold that a modified version of the business
judgment rule is the appropriate legal standard in such circumstances. Unlike the traditional
approach, the modified business judgment rule places an initial burden on directors to
demonstrate that they acted reasonably, in good faith, and in a disinterested fashion
in arriving at their decision to reject a shareholder’s demand or to terminate
existing litigation. We further hold that the lower courts correctly applied that standard
when dismissing the derivative litigation in this case.
This appeal stems from four derivative actions brought by shareholders of Public Service Enterprise Group, Incorporated (Enterprise), a public utility holding company, and its wholly-owned subsidiary, Public Service Electric & Gas Company (PSE&G) (collectively, the company). Defendants are certain directors of both entities, and include current and former PSE&G officers. (For convenience, we do not distinguish between members of the Enterprise and PSE&G boards; unless otherwise indicated, we refer to them collectively as the Board.)
PSE&G operates the Salem and Hope Creek nuclear power plants located in southern New Jersey. During the relevant period, a series of malfunctions and safety violations plagued the Salem plant, causing federal regulators to assess significant fines against the company. Hope Creek also experienced problems, but not as frequently as those that had occurred at Salem. In a nutshell, plaintiffs allege that defendants recklessly mismanaged both facilities to the company’s financial detriment.
We recount the most noteworthy events. In February 1983, the Salem plant’s reactor protection systems failed to operate automatically, requiring employees to shut down the reactors manually. Later, in November 1991, one of the turbines at the Salem plant exceeded its normal speed, causing parts of several blades to fly off its shaft. In December 1992, nuclear department managers were accused of harassing two engineers who tried to file an incident report in response to a safety concern at the plant. In that same month, an employee inadvertently turned off the plant’s overhead annunciator system, which alerts plant employees to alarm conditions. That misstep went undetected by management and operations personnel for ninety minutes.
In 1993, management and equipment failures continued to plague the Salem facility. In June of that year, PSE&G shut down Salem unit two due to a failure in the rod control system. One year later, PSE&G shut down Salem unit one and declared an alert when marsh grass clogged that unit’s water coolant system. In 1995, PSE&G shut down both Salem units because of a failure of two different pieces of equipment.
In 1995, problems also arose at the Hope Creek plant. In April, a release of radioactive material occurred during maintenance operations. Three months later, a planned shutdown went awry when the plant’s operators left a discharge valve open, causing an increase in the reactor coolant temperature.
The United States Nuclear Regulatory Commission (NRC) took action in response to each event at the Salem and Hope Creek facilities. After the 1983 shutdown, the NRC revised the Salem license, requiring remedial actions to assure the safe operation of the plant. Following each of the 1991, 1992, and 1993 incidents, the NRC sent a special team to conduct immediate safety inspections of the Salem plant. Due to the severity of Salem’s 1995 malfunctions, the NRC prohibited PSE&G from re-starting either unit at Salem without the agency’s prior approval. The NRC placed the plant on the agency’s “watch list” in 1997.
In January 1995, the NRC issued its Systematic Assessment of Licensee Performance (SALP) rating of the Salem plant for the period June 20, 1993, to November 5, 1994. The NRC gave the Salem plant a “3” rating, the lowest possible score, in the Operations and Maintenance categories. That resulted in a 2.25 overall rating for the plant, placing it in the bottom quartile nationally. In March 1995, representatives of the NRC, including its executive director of operations, met with members of the Board in response to those SALP ratings. One Board member explained that a meeting of that nature was a “rare event.” By the end of 1995, the NRC had assessed over $2 million in fines against PSE&G in response to the ongoing violations at the Salem and Hope Creek facilities. The SALP rating of the Hope Creek Plant also was lowered. Finally, another nuclear-utility oversight organization, the Institute of Nuclear Power Operations (INPO), issued poor ratings for both the Salem and Hope Creek plants.
In response to the Salem and Hope Creek events, the Board took steps to gather information regarding the shortcomings of the facilities and the concerns raised by the NRC and INPO. Following the 1983 incident at the Salem plant, the Board created the Nuclear Oversight Committee (NOC) that was comprised of a Board liaison and outside experts in the nuclear energy field. The NOC was charged with receiving information regarding PSE&G’s operations, preparing reports for the Board, and making recommendations based on that information. In 1995, the Board replaced the NOC, reconstituting it as a committee of the Enterprise board.
In 1994, PSE&G created its own Nuclear Review Board (NRB). Similar to the former NOC, the NRB is comprised of outside experts in the nuclear field and PSE&G senior nuclear personnel. The NRB’s function is to review the nuclear operations of PSE&G and to provide counsel to both PSE&G’s chief nuclear officer and the Enterprise board regarding the company’s nuclear safety and operational performance. From 1983 to 1997, the Board also received information regarding nuclear operations from PSE&G’s senior officers and other senior management personnel. Representatives of both the NRC and INPO attended Board meetings and advised that group directly regarding nuclear operations.
In 1989, the Board instituted a revitalization program at the Salem plant, in respect of which the company spent $300 million to upgrade equipment and facilities. The Board also intended the program to improve procedures and personnel. Those actions resulted in a favorable review by the NRC for the 1991-1993 period, although the agency noted that the company was slow in responding to some concerns. In 1994, after receiving an internal report that acknowledged the need to “change the culture” at Salem, the Board replaced its chief nuclear officer. However, as evidenced by declining SALP ratings and the subsequent 1995 closure of the Salem plant, those changes had limited effectiveness.
On October 4, 1995, following the closing of the Salem units, plaintiff G.E. Stricklin sent a demand letter to the Board asking it to institute suit against “each of its officers” for alleged mismanagement of the company’s nuclear operations. Stricklin claimed that the Board’s failure to take prompt action to correct the problems at the Salem and Hope Creek plants resulted in millions of dollars of damages to the company, only a portion of which could be recovered from ratepayers. Stricklin also alleged that members of the Board purposely had failed to disclose PSE&G’s difficulties in a timely manner to ensure their re-election to the Board itself. Although she believed the demand effort to be futile, Stricklin designed her letter “to satisfy any conceivable requirement that a formal demand be made prior to the commencement of derivative litigation.”
In response to Stricklin’s letter, the Board adopted a resolution on October 17, 1995, retaining the law firm of Kasowitz, Benson, Torres & Friedman (the Kasowitz firm). The Board directed the firm to investigate the allegations raised in the demand letter.
On December 27, 1995, before the Kasowitz firm had completed its work, Stricklin filed a shareholder derivative complaint against defendants in the Superior Court, Law Division in Camden County. The complaint raises substantially the same allegations as the demand letter, and contends that Board members should be held personally liable for the company’s financial losses. Plaintiff also asserts that her earlier demand on the Board had been rejected wrongfully because at the time of her complaint the Board had not acted in response to her demand.
On February 13, 1996, the parties entered into a stipulation to extend time to answer or otherwise respond to the complaint so that the Board could complete its investigation. Shortly before that date, on February 8, 1996, the Kasowitz firm issued a 124-page report regarding its investigation of Stricklin’s demand. The firm focused its report on the period following January 1, 1993, because, among other reasons, Stricklin did not own stock in the company prior to that date.
The firm reviewed over 43,000 pages of documents, including Board minutes, internal reports, and documents generated by the NRC and other agencies. The firm also conducted over thirty interviews with Enterprise and PSE&G personnel. The firm did not interview plaintiff’s representatives because they had refused the firm’s request for a meeting. Based on its review, the Kasowitz firm concluded that there was no basis for Enterprise to institute legal action against any employee, officer, or director of Enterprise or PSE&G in respect of the Salem and Hope Creek facilities.
More specifically, the report concluded that the Board had attempted, in a diligent and good-faith manner, to address the issues at both the Salem and Hope Creek sites and to discover and remedy deficiencies in equipment and management. The report further determined that the Board had established an information network that ensured that the material issues that arose in the facilities were brought to the Board’s attention promptly and completely. The report cited the NOC and its successor committee as the primary conduits for that information. The report also found that the Board was informed sufficiently by independent nuclear experts.
The report addressed the steps that the Board had taken in response to the problems at the facilities. The report noted that the Board had changed reporting structures and created a new nuclear business unit to establish a greater familiarity with the company’s nuclear business. Further, the report detailed the personnel changes made by the Board to improve the culture and management at the facilities. Finally, the report described plans like the 1989 Salem revitalization program instituted by the Board to upgrade equipment and facilities.
Based on those findings, the firm concluded that the members of the Board remained informed about the material issues regarding the Salem and Hope Creek sites and addressed those issues, to the extent that they could, in a timely and businesslike manner. After reviewing the applicable law, the firm determined that the directors’ actions would be protected under the business judgment rule. The firm also found that the directors and officers would be protected by a provision in the company’s certificate of incorporation that provides that directors and officers “shall not be personally liable to the corporation or its shareholders” for “breach of any duty owed to the corporation or its shareholders.”
The report found no evidence that the Board had breached its duty to disclose information relating to the company’s nuclear operations. Finally, the firm concluded that even if grounds for a suit did exist, instituting such litigation might not be in the company’s best interests due to significant legal costs, negative publicity, and the effect on employee morale and recruitment. The firm also believed that a lawsuit would damage the company’s relationship with the NRC.
While the Board was reviewing the Kasowitz report, two other sets of plaintiffs instituted separate suits against defendants in the Superior Court, Chancery Division in Essex County. Dr. Steven Fink and Dr. David Friedman, P.C. Profit Sharing Plan (Fink) filed suit on February 28, 1996, and A. Harold Datz Pension and Profit Sharing Plan and Gail Dorff (collectively, Datz) filed an action on March 5, 1996. Both complaints allege Board mismanagement of the Salem and Hope Creek sites. Fink and Datz, however, did not make a demand on the company prior to instituting suit. Instead, those plaintiffs assert that such demand would have been futile. Fewer in number as compared to the defendants named by Stricklin, the Fink and Datz defendants overlap to some extent with the Stricklin defendants. (The fact that some defendants may differ is not relevant to our disposition.)
In response to the Fink and Datz complaints, the Kasowitz firm submitted a supplemental report on March 14, 1996. The firm expanded the scope of its review to include the October 1989 to December 1992 time period. According to the supplemental report,
with respect to present or former officers and directors of Enterprise and PSE&G, and in connection with the general management of nuclear operations of the Salem and Hope Creek units . . . , there is no evidence of any act or omission known or believed to be contrary to the best interests of Enterprise, its shareholders or PSE&G in connection with a matter in which there was a material conflict of interest; no evidence of bad faith or knowing violation of law; no evidence of any receipt of an improper personal benefit; and no evidence of gross negligence.
As a result, the firm maintained its original recommendation that no litigation was
necessary.
On March 19, 1996, the Board adopted a resolution accepting the Kasowitz firm’s
recommendations. Later, in deposition testimony or in individual certifications, each Board member gave
several reasons for rejecting the litigation. Collectively, they cited: (1) the memorandum and
reports presented by counsel, (2) the inquisitiveness and preparedness of Board members at
meetings, (3) the open lines of communication and information in respect of the
company’s nuclear operations, (4) the depth of the information presented to the Board
on a regular basis and its vigorous action in response to that information,
and (5) the excessive cost of such litigation.
Notwithstanding the Board’s rejection of her demand, Stricklin proceeded with her action. In April 1996, her case was transferred from the Superior Court, Law Division in Camden County to the Chancery Division in Essex County, where the Fink and Datz actions had been venued. On July 3, 1996, a fourth shareholder, Tillie A. Greenberg, filed a complaint in the Chancery Division in Essex County, similar to the Stricklin complaint. The trial court consolidated the actions that same month.
Defendants moved to dismiss all four actions. The trial court denied that motion in December 1996. Specifically, the court excused Fink and Datz from the demand requirement, determining that the shareholders had alleged sufficient facts to create a reasonable doubt that the directors were disinterested or independent. The court ultimately concluded that all four plaintiffs had alleged sufficient facts to withstand dismissal. Defendants moved for leave to appeal that decision to the Appellate Division, which denied the motion, and to this Court, which also denied relief.
The consolidated cases were transferred to a different Chancery Division judge. In November 1997, the new judge bifurcated the Stricklin and Greenberg actions (which the court treated as demand-made cases) and the Fink and Datz actions (the demand-futile cases). In December 1997, defendants moved for summary judgment in the demand-made actions. In disposing of that motion, the trial court considered two critical questions. In re PSE&G Shareholder Litig., 315 N.J. Super. 323, 325 (Ch. Div. 1998). The first issue focused on the appropriateness of the business judgment rule in evaluating the Board’s decision to terminate the litigation. Ibid. The second question pertained to the scope of possible discovery to which the demand-made plaintiffs might be entitled. Ibid.
In a reported decision, the court adopted a modified version of the business judgment rule that places an initial burden on a corporation to establish the independence, good faith, and reasonableness of directors in rejecting a shareholder’s complaint. Id. at 336. Further, the court ordered defendants to provide discovery to plaintiffs, “limited to the narrow issue of what steps the directors took to inform themselves of the shareholder demand and the reasonableness of its decision.” Id. at 337.
In May 1998, defendants moved for summary judgment in the demand-futile actions. In an unreported opinion, the trial court reserved ruling on that motion based on its view that the standard of review that it had enunciated in its reported decision could not be applied to the Fink and Datz actions in the absence of discovery. Similar to its decision in the suit by the demand-made plaintiffs, the court permitted the demand-futile plaintiffs to conduct discovery regarding the Board’s disinterestedness, good faith, due care, and the reasonableness of its decision to terminate the litigation.
Following discovery, the trial court granted summary judgment in favor of defendants and against all plaintiffs. In an unreported decision, the court meticulously analyzed each allegation within the framework of the modified business judgment rule. Under that rubric, the court rejected both the demand-made and demand-futile claims. All plaintiffs except Greenberg appealed. Also in an unreported decision, the Appellate Division affirmed all aspects of the trial court’s disposition.
We granted plaintiffs’ petition for certification, 170 N.J. 386 (2001). We also granted amicus curiae status to the New Jersey Chamber of Commerce (Chamber). Although it agrees with the trial court’s ultimate disposition, the Chamber argues that we should not alter the existing formulation of the business judgment rule in these circumstances.
II.
To resolve this dispute, we are required to analyze the interplay between two established, but sometimes competing, corporate doctrines. The first doctrine accords protection to corporate decision-makers to be free of unwarranted judicial intrusion when making business judgments on behalf of the corporation. The second tenet recognizes a shareholder’s ability to redress perceived wrongs against the corporation by filing a derivative lawsuit when the entity’s managers refuse to act. We must strike an appropriate balance between both doctrines. Because shareholder-derivative litigation is not an everyday occurrence in our courts, we are confronting some issues for the first time.
We first review a basic principle, the business judgment rule. Having many facets, the rule is embedded in American corporate law. See R. Franklin Balotti and James J. Hanks, Jr., Rejudging the Business Judgment Rule, 48 Bus. Law 1337, 1337-40 (1993) (describing procedural and substantive aspects of business judgment rule). “The business judgment rule protects a board of directors from being questioned or second-guessed on conduct of corporate affairs except in instances of fraud, self-dealing, or unconscionable conduct.” Maul v. Kirkman, 270 N.J. Super. 596, 614 (App. Div. 1994).
One of the rule’s purposes is to “promote and protect the full and free exercise of the power of management given to the directors.” Ibid. (citing 3A William M. Fletcher, Fletcher Cyclopedia of Law of Private Corporations, § 1039 at 45 (perm. ed. rev. vol. 1986)). New Jersey courts have long accepted that
a decision made by a board of directors pertaining to the manner in which corporate affairs are to be conducted should not be tampered with by the judiciary so long as the decision is one within the power delegated to the directors and there is no showing of bad faith.
[Exadaktilos v. Cinnaminson Realty Co.,
167 N.J. Super. 141, 151 (Law Div. 1979).]
The business judgment rule “is a rebuttable presumption[.]” Maul, supra, 270 N.J. Super.
at 614. It places an initial burden on the person who challenges a
corporate decision to demonstrate the decision-maker’s “self-dealing or other disabling factor.” Ibid. (internal
quotation marks and citation omitted). If a challenger sustains that initial burden, then
the “presumption of the rule is [] rebutted, and the burden of proof
shifts to the defendant or defendants to show that the transaction was, in
fact, fair to the corporation.” Stuart L. Pachman, Title 14A-Corporations at 228 (2000)
(citing Maul, supra, 270 N.J. Super. at 614).
One recognized infringement on director autonomy is the shareholder-derivative action. As the name implies, “[a] shareholder derivative action permits a shareholder to bring suit against wrongdoers on behalf of the corporation, and it forces those wrongdoers to compensate the corporation for the injury they have caused.” Bradley T. Ferrell, Note, A Hybrid Approach: Integrating the Delaware and the ALI Approaches to Shareholder Derivative Litigation, 60 Ohio St. L.J. 241 (1999) (footnote omitted). In that circumstance, “the cause of action actually belongs to the corporation, but a shareholder is permitted to assert the cause of action where the corporation has failed to take action for itself.” Id. at 241-42 (footnote omitted).
Derivative litigation raises difficult and sometimes controversial issues. Id. at 242-43. One difficulty is that, although such litigation may compensate the corporation for injuries sustained as a result of wrongful conduct, it also may have a negative effect on corporate governance when frivolous lawsuits initiated by opportunistic shareholders are brought. Id. at 243. If abused, derivative litigation can impede the best interests of the corporation. Ibid. See also James D. Cox, Searching for the Corporation’s Voice in Derivative Suit Litigation: A Critique of Zapata and the ALI Project, 1 982 Duke L.J. 959, 960 (noting that because derivative-suit plaintiff “usually has no significant financial interest in the corporation, the possibly harmful economic effects of prosecuting the suit cannot be expected to guide his decision to litigate”) (footnote omitted).
In response to those concerns most jurisdictions require as a prerequisite to derivative litigation that shareholders make a demand on the corporation’s board of directors to act. Carol B. Swanson, Juggling Shareholder Rights and Strike Suits in Derivative Litigation: The ALI Drops the Ball, 77 Minn. L. Rev. 1339, 1341 (1993). The demand requirement serves at least two purposes. First, it provides corporate managers with the opportunity to address a shareholder’s claims. Along those lines, if the board determines that the allegations are meritorious it may choose to remedy the situation internally or embrace the litigation. Id. at 1349-50. Second, if managers disagree with the shareholder’s concerns, the demand requirement provides the board with an opportunity to reject the demand and, if necessary, seek early dismissal of the suit. Id. at 1350.
Most jurisdictions will excuse demand if the shareholder can establish that making it would be futile. Id. at 1351. New Jersey recognizes the demand-futility doctrine. In re Prudential Ins. Co. Litig., 282 N.J. Super. 256, 275 (Ch. Div. 1995). Our procedures are codified under Rule 4:32-5, which states, in part:
In an action brought to enforce a secondary right on the part of one or more shareholders in an association, incorporated or unincorporated, because the association refuses to enforce rights which may properly be asserted by it, the complaint shall be verified and allege that the plaintiff was a shareholder at the time of the transaction complained of, or that the share thereafter devolved by operation of law. The complaint shall also set forth with particularity the efforts of the plaintiff to secure from the managing directors or trustees and, if necessary, from the shareholders such action as is desired, and the reasons for the failure to obtain such action or the reasons for not making such effort.
[(Emphasis added).]
See also In re Midlantic Corp. Shareholder Litig.,
758 F. Supp. 226, 239
(D.N.J. 1990) (noting that plaintiff is required to make demand under Rule 4:32-5
unless excused from doing so under state law).
Until today, this Court has not had the occasion to formulate or apply
a standard for evaluating demand futility actions under Rule 4:32-5. One prior case,
Escoett v. Aldecress Country Club,
16 N.J. 438 (1954), touched on that issue
from the perspective of a demand made on a general body of stockholders
under R.R. 4:36-2, the predecessor to Rule 4:32-5. Escoett, however, did not address
the issue of when demand should be excused within the context of a
board of directors. Although this Court has not spoken directly to the issue,
the Chancery Division in Prudential, supra, adopted a two-part test to be applied
in such circumstances. 282 N.J. Super. at 275. The test is derived from
a standard articulated by the Delaware Supreme Court in Aronson v. Lewis,
473 A.2d 805 (1984), overruled on other grounds, Brehm v. Eisner,
746 A.2d 244
(Del. 2000).
Under Aronson, a trial court must decide “whether, under the particularized facts alleged,
a reasonable doubt is created that: (1) the directors are disinterested and independent
and (2) the challenged transaction was otherwise the product of a valid exercise
of business judgment.” Aronson, supra, 473 A.
2d at 814. Notwithstanding Aronson’s use of
“and” in its test, the Delaware Supreme Court in Brehm, supra, clarified that
“[t]hese prongs are in the disjunctive. Therefore, if either prong is satisfied, demand
is excused.” 746 A.
2d at 256 (footnote omitted).
Prudential provides a good illustration of these concepts. In that case, Prudential Insurance
Company (Prudential) acquired Bache Group, renaming it Prudential Securities, Inc. (PSI). Prudential, supra,
282 N.J. Super. at 263. The acquired entity specialized in retail brokerage and
“embarked on an aggressive campaign to increase revenue by selling a package of
investment products.” Id. at 264. As part of its campaign, PSI “marketed approximately
$8 billion in limited partnership interests and other direct investments throughout the United
States.” Ibid. The marketing operation, known as the “Limited Partnership Program,” included “offerings
purportedly consist[ing] of illiquid and highly speculative partnerships in oil and gas investments,
real estate, aircraft leasing, and horse breeding.” Ibid. Although Prudential terminated its investments
in oil and gas partnerships because it had considered them poor risks, “PSI
continued to promote energy partnerships as sound investments.” Ibid.
The Securities and Exchange Commission (SEC) investigated PSI’s Limited Partnership Program and “found
that PSI had committed extensive securities fraud violations in conjunction with its marketing
and sale of limited partnership interests, including misrepresenting speculative, illiquid limited partnerships as
safe, income-producing investments.” Id. at 265. At about the same time, PSI became
the subject of “thousands of legal proceedings brought by investors in the limited
partnership seeking recoveries of the amounts paid and/or compensatory damages.” Id. at 264.
PSI incurred significant liabilities. The SEC fined PSI $10 million, various states assessed
it $26 million in penalties for violations of state securities laws, and the
National Association of Securities Dealers fined it $5 million for industry rule violations.
Id. at 265.
On those facts, two policyholders of Prudential filed a derivative suit against the
executives of PSI and Prudential, the Prudential board of directors, and Prudential itself.
Id. at 260-61. Their complaint alleged breach of fiduciary duty; waste, mismanagement, and
gross negligence; intentional misrepresentation; and negligent misrepresentation. Id. at 261. The plaintiffs did
not make a demand on Prudential’s board of directors before filing suit. Id.
at 262. Accordingly, the defendants moved to dismiss the derivative claims pursuant to
Rule 4:32-5. Ibid.
Applying the two-prong Aronson test, the Prudential court ruled in favor of defendants,
holding that the plaintiffs had “failed to plead with the particularity required by
R. 4:32-5 why demand should be excused.” Id. at 285. As to the
first prong, the court found that the plaintiffs’ allegations that the directors were
“not disinterested or independent and that they [were] controlled by the ‘defendants at
the heart of the wrongdoing[,]’” were mere “conclusory allegations[.]” Id. at 277. As
such, they were insufficient to excuse demand. Ibid. The court further noted that
the plaintiffs’ complaint did not differentiate among directors and other defendants, nor did
it “plead any facts showing that past directors had actual knowledge of the
alleged wrongdoings at the time that they were committed.” Ibid.
The court also rejected the plaintiffs’ claim that the defendants were “self-interested because
they [did] not want to sue themselves, their friends and their business associates.”
Id. at 278. The court observed:
“[T]he incantation that demand is excused because the directors otherwise would have to
sue themselves [is a] bootstrap argument [which] has been made to and dismissed
by other courts. . . . Its acceptance would . . . weaken
the managerial power of directors. Unless facts are alleged with particularity to overcome
the presumptions of independence and a proper exercise of business judgment, in which
case the directors could not be expected to sue themselves, a bare claim
of this sort raises no legally cognizable issue.”
[Ibid. (quoting Aronson, supra, 473 A.
2d at 818).]
Applying the second prong, the court distinguished between action and inaction, explaining that
“‘the absence of board action . . . makes it impossible to perform
the essential inquiry contemplated by Aronson, whether the directors have acted in conformity
with the business judgment rule in approving the challenged transaction.’” Id. at 283
(quoting Rales v. Blasband,
634 A.2d 927, 933 (Del. 1993)). The court determined
that plaintiffs’ complaint focused largely on director inaction, namely, the failure of the
Prudential directors “to supervise a subsidiary” and “more generally, to stop the alleged
illegal actions of the executive defendants[.]” Id. at 284. As a result, the
court concluded that no further analysis under Aronson’s second prong was required. Id.
at 285. See also Aronson, supra, 473 A.
2d at 813 (explaining that business
judgment rule “has no role where directors have either abdicated their functions, or
absent a conscious decision, failed to act”); Rales, supra, 634 A.
2d at 933-34
(observing in essence that Aronson’s second prong does not apply “where the board
that would be considering the demand did not make a business decision which
is being challenged in the derivative suit”).
We are satisfied that the Aronson two-prong inquiry, as illustrated in In re
Prudential, represents the appropriate standard for evaluating demand futility. The test strikes the
appropriate balance between director autonomy and the interests of shareholders in this context.
See Pachman, supra, at 219-222 (discussing respective rights of directors and shareholders under
New Jersey law). Accordingly, for shareholder plaintiffs in New Jersey to withstand a
motion to dismiss for failure to make a demand, they must plead with
particularity facts creating a reasonable doubt that: (1) the directors are disinterested and
independent, or (2) the challenged transaction was otherwise the product of a valid
exercise of business judgment. If either prong is satisfied, demand will be excused
under Rule 4:32-5.
Delaware law also permits a corporation’s board to seek dismissal of a derivative suit in a demand-excused context. Zapata Corp. v. Maldonado, 430 A.2d 779, 789 (Del. 1981). In such demand-excused cases, the board may appoint a special litigation committee to investigate whether the suit is in the best interest of the corporation. Id. at 786. Numerous jurisdictions emulate Delaware’s approach. Ferrell, supra, 60 Ohio St. L.J. at 249-50. Based on the committee’s findings, the corporation may move for dismissal of the suit, although the corporation has the burden of proving the “independence,” “good faith,” and “reasonableness” of the committee’s investigation. Zapata, supra, 430 A. 2d at 788. When circumstances warrant, boards also might rely on special litigation committees in demand-made cases to determine whether a suit should proceed in response to a shareholder’s demand. PSE&G, supra, 315 N.J. Super. at 329; Pachman, supra, at 94.
This case does not implicate a special litigation committee because defendants did not create one to evaluate the shareholders’ claims. That said, we find nothing in the New Jersey Business Corporation Act, N.J.S.A. 14A:1-1 to 14A:17-18, that would preclude the use of a special litigation committee in this setting. We are not required in this appeal to consider a board’s limitations, if any, on its establishment and use of a special litigation committee. See Houle v. Low, 556 N.E.2d 51, 54, 57 (Mass. 1990) (surveying varying judicial decisions on use of special litigation committees). For today’s purposes it is sufficient for us to state that, as a general framework for analysis, we will “not differentiate between cases where a shareholder litigation committee investigated the demand and cases in which demand was refused by the board.” PSE&G, supra, 315 N.J. Super. at 329 n.1.
Whether or not demand is excused, the issue becomes what level of judicial scrutiny should be applied when reviewing management’s response to shareholder-derivative litigation. Courts generally apply the traditional business judgment rule or one of many variations of the rule in evaluating a board’s response. Ferrell, supra, 60 Ohio St. L.J. at 251 n.36 (stating that “[t]here are at least five different standards presently being applied by various jurisdictions across the country”). We agree with those courts that apply a single standard of review in both demand-made and demand-excused cases. See, e.g., Alford v. Shaw, 358 S.E.2d 323, 327 (N.C. 1987) (drawing no distinction “between demand-excused and other types of cases” for purposes of judicial review); Lewis v. Boyd, 838 S.W.2d 215, 224 (Tenn. Ct. App. 1992) (observing that “depth of review should not depend on whether or not the shareholder made a demand prior to filing suit”).
The seminal case that exemplifies the deferential or traditional approach is Auerbach v. Bennett, 47 N.Y.2d 619 (1979). In Auerbach, a shareholder commenced a derivative action following a report by an audit committee of General Telephone & Electronics Corporation (GT&EC) that disclosed more than $11 million in illegal bribes paid by GT&EC to third parties. Id. at 624-25. The shareholder plaintiffs named four of the thirteen corporate directors as the defendants. Id. at 625 n.2. In response, the corporation created a special litigation committee consisting of three disinterested directors who did not sit on the board at the time that the alleged transactions occurred. Id. at 625.
The committee’s examination revealed that the audit conformed to accepted auditing standards. Ibid. Further, the committee concluded that none of the individual directors violated New York’s statutory standard of care or profited personally by the alleged acts. Ibid. The committee determined that it would not be in the best interest of the corporation for the derivative action to proceed and directed the corporation’s general counsel to assert that position in the then-pending litigation. Id. at 626. As a result, the corporation and the individual defendants moved to dismiss the plaintiff’s action. Ibid.
New York’s highest court considered whether to apply the business judgment rule when evaluating the decision of a special litigation committee. Id. at 629. The court determined that its inquiry should be limited to an examination of the committee’s independence and the sufficiency of its procedures. Id. at 623-24. It further emphasized that “[w]hile the court may properly inquire as to the adequacy and appropriateness of the committee’s investigative procedures and methodologies, it may not under the guise of consideration of such factors trespass in the domain of business judgment.” Id. at 634.
Courts in other jurisdictions follow the Auerbach approach. Genzer v. Cunningham, 498 F. Supp. 682, 686-89 (E.D. Mich. 1980); Will v. Engebretson & Co., 261 Cal. Rptr. 868, 872-73 (1989); Black v. NuAire, Inc., 426 N.W.2d 203, 209-10 (Minn. Ct. App. 1988). Essentially, those courts treat management’s decision to reject a shareholder suit similar to the treatment of other business decisions. Swanson, supra, 77 Minn. L. Rev. at 1363. That traditional approach has been applauded in some quarters because it recognizes that courts are not equipped to handle sophisticated corporate decision making. Kelly M. Crain, Comment, Decisions of Special Litigation Committees: Solving the Problem of Control Under Texas Law, 44 Baylor L. Rev. 171, 180 (1992). It also preserves corporate autonomy to the greatest extent possible. Swanson, supra, 77 Minn. L. Rev. at 1359-60.
Notwithstanding those asserted benefits, the traditional approach is not without its critics. Some consider the rule extremely differential to directors, making it difficult for shareholders to maintain a derivative suit due to discovery limitations and their general inability to obtain facts necessary to overturn a board’s decision. Id. at 1364; Crain, supra, 44 Baylor L. Rev. at 181. Responding to those criticisms, the trial court in this case eschewed the traditional approach. PSE&G, supra, 315 N.J. Super. at 335. The court explained that “[r]equiring shareholders to allege facts with specificity without discovery places them in a position bordering on the impossible.” Ibid. The court cited other jurisdictions that have concluded similarly that Auerbach accords too much deference to a board of directors or its special litigation committee in evaluating derivative litigation. Id. at 330-31 (citing Alford, supra, 358 S.E. 2d at 326; Houle, supra, 556 N.E. 2d at 58-59; Lewis, supra, 838 S.W. 2d at 224).
We believe that the trial court correctly declined to apply the traditional business judgment rule in this case. Instead, we shall apply a modified business judgment rule that imposes an initial burden on a corporation to demonstrate that in deciding to reject or terminate a shareholder’s suit the members of the board (1) were independent and disinterested, (2) acted in good faith and with due care in their investigation of the shareholder’s allegations, and that (3) the board’s decision was reasonable. PSE&G, supra, 315 N.J. Super. at 335. All three elements must be satisfied. Moreover, shareholders in these circumstances must be permitted access to corporate documents and other discovery “limited to the narrow issue of what steps the directors took to inform themselves of the shareholder demand and the reasonableness of its decision.” Id. at 337.
As the trial court more fully explained:
The adoption of a modified business judgment rule, the key feature being that the corporation, not the shareholder, would have to meet an initial burden of proof is more consistent with the realities of shareholder-corporate existence. Courts would have to dismiss a shareholder derivative suit in accordance with management’s recommendation so long as the corporation could establish the decision maker acted reasonably, in good faith, and in a disinterested fashion. The [] standard would not permit the court to substitute its own business judgment for that of management. In determining whether the corporation has met its burden, the court would be able to consider all relevant justifications for management’s determination, including the seriousness and weight of the plaintiff’s allegations.
There are differences and similarities between the test for determining demand-futility under Rule 4:32-5 and the standard for evaluating a board’s decision under the modified business judgment rule. The main distinction is that a plaintiff has the burden of demonstrating demand-futility, whereas a defendant has the burden of satisfying the elements of the modified business judgment rule. Further, when a court decides a defendant’s motion to dismiss a shareholder’s suit for failure to make a demand as required under Rule 4:32-5, the court’s review is generally limited to the pleadings. Prudential, supra, 282 N.J. Super. at 267. In contrast, under the modified business judgment rule, a plaintiff is entitled to a degree of discovery prior to a court’s ruling on whether a corporation properly has determined to reject or terminate the litigation.
When a court evaluates demand-futility, “[p]laintiffs are entitled to all reasonable factual inferences that logically flow from the particularized facts alleged, but conclusory allegations are not considered as expressly pleaded facts or factual inferences.” Brehm, supra, 746 A.2d at 255; accord, Prudential, 282 N.J. Super. at 276-78. If the court denies a Rule 4:32-5 motion and relieves a shareholder of the demand requirement, a defendant may later renew its motion to dismiss the litigation, as was done here. At that juncture, however, the court would evaluate the motion by applying the burden-shifting and other aspects of the modified business judgment rule.
We also make clear that an appellate court’s review of a trial court’s decision under either Rule 4:32-5 or the modified business judgment rule is de novo on the record. Along those lines, we agree with the Supreme Court of Delaware that stated recently in a case involving whether a group of shareholders had alleged sufficient facts to excuse demand:
Our review is not a deferential review that requires us to find an abuse of discretion. We see no reason to perpetuate the concept of discretion in this context. The nature of our analysis of a complaint in a derivative suit is the same as that applied by the Court of Chancery in making its decision in the first instance.
[Brehm, supra, 746 A.
2d at 253.]
The test under Rule 4:32-5 and the modified business judgment rule are similar
in that they both implicate whether directors are disinterested and independent. Notwithstanding that
similarity, a court applying the modified business judgment rule is not bound by
any finding associated with an earlier court’s decision to excuse demand. See Hart
v. City of Jersey City,
308 N.J. Super. 487, 497-98 (App. Div. 1998)
(outlining circumstances to permit second judge on same level as first judge to
differ with earlier ruling without violating “law of the case” doctrine). In that
respect, the court should consider the board’s decision under the modified business judgment
rule only after the parties have completed adequate discovery to enable the court
to render a fully-informed decision.
For completeness, we note that some commentators have proposed repealing the demand-futility doctrine,
arguing that it requires courts to “engag[e] in a tortured inquiry of whether
demand is excused.” PSE&G, supra, 315 N.J. Super. at 334. In its place,
they would require a universal-demand requirement, coupled with a standard of review similar
to the modified business judgment rule adopted here. Swanson, supra,
77 Minn. L.
Rev. at 1387-90. In our view, the demand-futility doctrine retains its usefulness for
that narrow group of cases in which the pleadings alone clearly provide a
basis for a court’s disposition.
More broadly, we are satisfied that the demand-futility doctrine and the modified business
judgment rule each serve a discrete but critical function. That is especially so
in a case in which a trial court first excuses demand and then
later applies the modified busin