NOTES
Liability of Directors to Shareholders for negligence
under American Law and their Indemnification
OUTLINE
I – THE POSITION OF THE CORPORATE DIRECTOR
A – The Director – Corporation relationship
B – The Director –
Shareholder relationship
I – Under Anglo-Canadian Law
2 – Under American Law
a -position
b -position of the director vis-h-vis individual shareholders
of the director vis-A-vis the body of shareholders
C – The Enforcement of the Director’s fiduciary duties:
The derivative suit
1 -Nature
2- The double-derivative action
of the action
Conclusion
II -LIABILITY FOR NEGLIGENCE
A – Basis of the liability
B – What constitutes actionable negligence?
to exercise the highest degree of care?
1 -Failure
2- Gross negligence?
3 – Ordinary negligence?
C -Analysis of the “ordinary care, prudence and skill” standard:
1 – The “own personal affairs” qualification
2 – The “ordinarily prudent man under similar circumstances”
qualification
3-Mistakes and errors of judgment
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D- Factors affecting the degree of care and possible defences
1-The kind of corporation
2- The knowledge available at time of decision
3-Honesty and good faith
4-Reliance upon counsel
5-Ilness and age
6-Custom and usage of business
7- Non-residence
8- Acts of officers and co-directors
9- Reliance upon officers
10- Appointment of an executive committee
III – AREAS OF LIABILITY
A – Securities Transactions
1-The Common Law Rules
a – The “majority” rule
b – The Kansas rule
c – The “special facts” rule
d- The common law principle of “half-truths”
e -Director’s
transactions on behalf of the corporation
2 -The Federal Corporation Law
A – The duty of disclosure
is a material fact?
a -What
b- When does a fact become a fact?
c -Sanctions
attached to the duty of disclosure
required reports
i –
ii – discretionary reports
iii – non-disclosure
B – The Standard of behaviour
a-Section 16(b) liability
scope
i-its
ii- what is a “sale” or “purchase” of a security?
–
-receipt
conversion of a convertible security
and disposal of stock pursuant to
mergers and acquisitions
-stock
options
b-Section 10(b) and (Rule 10b-5 liability
i- what is the lob-5 fraud?
–
– director’s conduct in period of non-disclosure
in general
No. 2]
NOTES
ii- who may be defrauded?
–
–
iii –
individuals
the corporation
remedies for violations of Section 10(b) and
Rule 10b-5
civil right of action: elements of a civil suit
–
– measure of damages
Conclusion
B- Transactions Involving Corporate Control
1 -The Sale of Control
a- The looting cases
b-The
c-The
corporate asset theory
theory of disguised premium for the corporate
product
d-The “corporate action” theory
e- The theory of the “Sale of corporate office”
f -Should
shareholders be offered an equal opportunity?
2-The
Protection of Control
V. Carey
a-Kors
b- Bennett v. Propp
c- Cheff v. Mathes
Conclusion: To whom belongs the “power to control”?
C – Conduct of Subsidiaries
1-The “fair dealings” principle
2-What
is “fair”?
a-The
“model contractual transaction” -test
!- The doctrine of Pepper V. Litton
ii – The “fraud” test
iii-The “good faith” test
“model corporate structure”
b-The
c- Tho “business judgment” test
D – Antitrust Violations
legislative background
1-The
2-Single damage suits by the United States
8- Treble damage suits against directors
a-Basis of the directors liability
the agency rule
i-
ii- Section 14 of the Clayton Act
b-Elements of the action
i- who may sue? .
ii-what
must be proven?
c- Proof of damages
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4-Derivative suits against directors
a- Elements of the derivative antitrust suit
b- The measure of damages
E- Tax and other Special Situations
1 -Tax decisions
2 – Corporate qualification
3 – Corporate undertakings
Conclusion
IV -THE PROTECTION OF DIRECTORS
A –
Indemnification
1 -Derivative action
a – The principle
b- What should be indemnified when there is no adjudication
on the merits ?
2 -Third party actions
a – Civil liability
i –
compensatory damage liability
– unintentionally inflicted harm
–
–
–
intentionally inflicted harm
liability without specification of fault
settlements and nolo pleas
ii – punitive damage liability
b – Criminal liability
c – Litigation expenses
B – Insurance
1 -Insurance purchased by the director
a- Nature of this insurance: indemnity or liability?
b-What can be covered?
i-Third party liability
ii – Liability to the corporation
2-
Insurance purchased by the corporation
Insurance protecting the corporation
a-
i- coverage against directors’ breach of duty
ii –
coverage against indemnification expenses
Insurance protecting the directors
i- Third party actions
ii- Shareholders’ derivative action
b-
CONCLUSION
No. 2]
NOTES
“Inside Trading”, “Disclosure”, “Short-swing profits”, “S.E.C.”,
“Rule 10b-5”, “Shareholders suits”, seem to be fashionable but
frightening expressions in today’s business community. The recent
appeal decision in the Texas Gulf ease 1 and the proceedings taken
by the Securities and Exchange Commission against Merrill, Lynch,
Pierce, Fenner and Smith Inc.2 seem to account for much of the
corporate directors’ worries. Though the personal liability of directors
in securities transactions is becoming increasingly important, this
is only one facet of the wide range of the liabilities of directors to
shareholders. The corporate director may be subject to heavy re-
sponsibilities both in the daily management of the company’s affairs
as well as in such specialized areas as corporate control, conduct of
subsidiaries or antitrust violations.
Some five Canadian provinces have enacted securities legislation 3
similar in many respects to the American Securities Act of 1933
and the Securities and Exchange Act of 1934; the Province of
Ontario now has the Ontario Business Corporations Act,4 in which
the standard of conduct expected of directors closely resembles that
of some American States. An assessment of the liabilities of American
directors to their shareholders has thus been thought to be of interest
to Canadian lawyers.
This study will be divided into four parts: the position of the
director, his liability for negligence, some areas of liability which
warrant a special degree of care from directors and how a director
can be protected from the monetary consequences of liability either
by indemnification or by insurance.
POSITION OF THE CORPORATE DIRECTOR
I -THE
A – The Director – Corporation relationship
With respect to the corporation, it seems well settled that the
director occupies the same position of trust as his Anglo-Canadian
counterpart.5 It should however be noted that various expressions
IS.E.C. V. Texas Gulf Sulphur Co., 258 F. Supp. 26?, (S.D.N.Y., 1966),
rev’d. in part (C.A. 2, Aug. 13th, 1968), Docket No. 30,882, p. 3587; 401 F.
2d 8933 (1088).
2 Securities & Exchange Act, 1934, S.E.C. Release No. 8394, August 27th, 1068.
3 Ontario Securities Act, 1066, c. 142 as amended; British Columbia Securities
Act, 1967, c. 45 as amended; Alberta Securities Act, 1.967, c. 76 as amended;
Saskatchewan Securities Act, 1.067, c. 81 as amended; Manitoba Securities Act,
1968, c. 57.
4 Ontario Business Corporations Act, 1070, 1.9 Eliz. II, c. 25.
519 C.J.S., para. 761, at p. 103; Fletcher, Cyclopedia of Corporations (Pean.
Ed.), para. 838.
McGILL LAW JOURNAL
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have been used by the courts to describe the relationship between
the director and the corporation: they have been termed trustees,6
under an implied or constructive trust, as the Court of Appeal of
Oklahoma once held:
An officer and director of corporation was not a trustee of an express
trust arising from contract or privity, but rather the trustee of an implied
or resulting trust created by operation of law from his official relation
to corporation, as respects liability to corporation for transactions with
it … 7
The more recent cases are not conclusive: some describe the
relationship as one having a fiduciary character,8 some others go
further and hold that:
[The] relationship of directors to their corporation was essentially that
of trustee and cestui que trust.9
In that respect, the position of the American director is not
different from that of his Canadian colleagues. In the well-known
case of Regal (Hastings) Ltd. v. Gulliver et. al., 0 the House of Lords
expressed the view that the various appellations used, e.g. agents,”
trustees,’12 managing partners,’3 are only convenient analogies to
describe a statutory position.’ 4
B – The Directors – Shareholders relationship
One of the main differences between our company law and that
of the United States, is the position occupied by directors vis-a-vis
the shareholders.
1- Under Anglo-Canadian Law
The clebrated case of Percival v. Wright I seems to have estab-
lished the absence of a fiduciary relationship between directors and
GAshman v. Miller, 101 F. 2d 85
(C.C.A. Mich.); U.S.A. v. Gates, 376 F.
2d 65 (C.A. Colo., 1967); Schoenbaum V. Firstbrook, 268 F. Supp. 385 (D.C.N.Y.,
1,967); Wilshire Oil Company of Tevas v. Riffe, 381 F. 2d 646
(C.A. 0kla.,
10,67).
7 Farmer v. Standeven, 93 F. 2d 959 (C.C.A. Ola.).
8 See cases cited supra, n. 6.
9Diamond v. Oreamuno, 2817 N.Y.S. 2d 300 (A.D. 1968), at p. 301.
1o [,1942] il All. E.R. -378, -at p. S87.
“Ferguson v. Wilson, [1866] L.R. 2 Ch. 77.
12 In re Exchange Banking Co. Flitoroft’s case, [1882] P1 Ch. D. 519, at
p. 525; Cape Breton Cold Storage Co. v. Rowlings, [1929] S.C.R. 505.
‘3 Automatic Self-Cleansing Filter Syndicate Co. Ltd. v. Cuninghame, [1906]
2 Ch. 34, at p. 45.
‘ 4 See also Wegenast, Canadian Companies, at p. 360, and, Fxaser and
Stewact, Company Law of Canada, (5th ed., 1962) at p. 584.
15 [1902] 2 Ch. 421.
No. 2]
NOTES
shareholders. 16 A good summary of the Canadian position may be
found in the Kimber Report:
The wide scope of this decision (Percival v. Wright) was qualified
to
a certain extent by the Privy Council in Allen V. Hyatt,17 where it was
held that in certain special circumstances there is a fiduciary relationship.
The extient -to which Allen V. Hyatt qualifies Percival v. Wright is uncer-
tain. It is probably limited to a very namow class of cases in which the
shareholder and the director meet virtually face-to-face and the director
is put in a fiduciary relationship by the conduct of the parties.’s
2- Under American Law
Under American law, a distinction is to be made between the
shareholders as a body and as -individual shareholders. The American
Courts, though disagreeing on the precise nature of the relationship,
hold that corporate directors stand in a fiduciary relationship to
the body of stockholders. The accepted principle seems to be that:
The directors of a corporation are intrusted with the management of its
business and property for the benefit of all the stockholders, and occupy
the position of trustees for the collective body of stockholders in respect
to such business. They are subject to the general rule, which prevails to
trust and trustees, that they cannot use the trust property, or their relation
is their duty to administer the
to it, for their own personal gain. It
corporate affairs for the common benefit of all stockholders, and exercise
their best care, skill and judgment in the management of the corporation
business solely in the interest of the corporation.’ 9
The -leading case of Ashman v. Miller adds that:
The ordinary trust relationship of directors of a corporation and stock-
holders is not a matter of statutory or technical law. It springs from the
fact that directors have the control and guidance of corporate business
affairs and property and hence of the property interests of the stock-
holders. 20
In 1932, the Harvard Law Review witnessed a great debate between
Professor Dodd and Professor Berle, the former asking “For whom
are corporate managers trustees” ? 21 the latter answering “For whom
corporate managers are trustees: ‘a note”.22 The issue raised was
whether the corporate managers’ responsibility is primarily owed
16 See Fraser and Stewart, op. cit., n. (14, at p. 587; Report of the Company
(1962), H.M.S.O. Cmnd. 1749, para. 89.
Law Committee, (Jenkins Report),
17 (1914), 17 D.L.R. 7.
‘S Report of the Attorney General’s Committee on Securities Legislation in
Ontario, (Kimber Report),
(1065) para. 2.22.
19Blum v. Fleischhacker, 2A1 F. Supp. 527, at p. 534; Pletcher, op. cit., n. 5,
para. 838, -at p. 179; 19 C.J.S. paxa. 761, at pp. 103-105; Berle, Corporate
Powers as Powers in Trust, 44 Harvard L.R. 1049.
20 101 F. 2d 85, at p. 91.
21 (1931), 45 Harvard Law Review 1145.
22 45 Harvard Law Review 1365.
McGILL LAW JOURNAL
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to the stockholders, that is, maximization of profits for the share-
holders or whether, as Professor Dodd contends, the corporation,
and therefore its management has a responsibility not only to the
shareholders but also to the security holders, the workers … in short
to the community at large. In whose favour the debate was resolved
was publicly admitted in 1954 by Professor A.A. Berle:
Twenty years ago, the writer had a controversy with the late Professor
E. Merrick Dodd, of Harvard Law School, the writer holding that corporate
powers were powers in trust for shareholders while Professor Dodd argued
that these powers were held in trust for the entire community. The
argument has been settled (at least for the time being) squarely in favor
of Professor Dodd’s contention. 23
What is the position of the directors towards individual share-
holders? It is common ground that where a stockholder or any other
individual has been personally aggrieved by the conduct of a director,
the director may be called upon to restore the damage.24 The loss
suffered must however be something more substantial than a
depreciation of stock since it has been held on numerous occasions
that the act of a director causing a decline in the value of the stock
held is not a sufficient cause of action, even if there is only one
shareholder. 25 In the above instances it may be said that the share-
holder does not sue qua shareholder but qua aggrieved person. The
area of litigation where the shareholder qua shareholder may have
a right of action is the field of securities transactions which shall
be dealt with later in this article. For the moment, we shall therefore
refrain from dwelling upon the question of whether a director stands
in a fiduciary relationship to individual shareholders in securities
transaction.
C – The Enforcement of the Director’s fiduciary duties:
the Derivative suit
If the individual stockholder is deemed to be a stranger to the
corporation, 26 this should mean that he could not enforce the corpo-
23A.A. Berae, The 20th Century Capitalist Revolution, .1954, at p. 169. For
a modern discussion of this controversy see: J.L. Wiener, The Berke-Dodd
Dialogue on the Concept of Corporation, 64 Colum. L.R. 1458.
24E.K. Buck Retail Stores v. Harkert, 62 N.W. 2d 288.
25 Funk V. Spalding, 246 p. 2d 184; Sutter v. General Petroleum Corporation,
f0 p. 2d 898; Green V. Victor Talking Machine Co., 24 F. 2d 78, cert. den.
278 U.S. 602; Cullum v. G.M.A.C., 115 S.W. 2d
,1.96; Smith v. Bramwell, 143
Or. 61X, (1934), K1 P. 2d 6417; Watson v. Button, 235 F. 2d 235 (C.A. 9, 1956),
at p. 237. See generally Baker and Cary, Cases on Corporations, (39 ed.
Unabr., 1959), at P. 636.
2619 Am. Jur. 2d para. 524.
No. 2)
NOTES
rate rights of action. The most he could do would be to demand that
the directors institute proceedings against themselves. As equity
will not suffer a wrong to be without a remedy, stockholders were
permitted to institute the so-called “derivative action” to enforce a
corporate right or to prevent or remedy a wrong to the corporation. 27
1 – Nature of the derivative action
The naiture of this action has been well summarized in the case
of Meyer v. Fleming where the Court expressed the view that:
Stockholder’s derivative suits are one of the remedies which equity designed
for those situations where the management through fraud, neglect of duty
or other cause declines to take the proper and necessary steps to assert
the corporation’s rights ..
The difference between an individual and a derivative action may
be expressed by the following excerpt from the opinion of the late
Justice Frankfurter in Swanson v. Traer:
.28
The contrasting difference between a stockholder’s suit for his corporation
and a suit by him against it,
is crucial. In the former, he has no claim
of his own; he merely has a personal controversy with his corporation
regarding the business wisdom or legal basis for the latter’s assertion of
a claim against third parties. Whatever money or property is to be recovered
would go to the corporation, not a fraction of it to the stockholder. When
such suit is entertained, the stockholder is in effect allowed to conscript
the corporation as a complainant on a claim that the corporation, in the
exercise of what it asserts to be uncoerced discretion, is unwilling to
initiate. This is a wholly different situation from that which arises when
the corporation is charged with invasion of the stockholder’s independent
right. Thus, for instance, if a corporation rearranges the relationship
of different classes of security-holders
to the detriment of one class,
a stockholder in the disadvantaged class may proceed against the corporation
as a defendant to protect his own legal interest.29
2- The double derivative action
Before leaving the subject of derivative actions it should be
noted that the view has been taken, 0 with some authority to the
contrary,31 that a stockholder in a corporation which holds stock in
27 lsaac V. Marcus, 258 N.Y. 257, 179 N.E. 487; Klopstock v. Superior Court,
108 P. 2d 906 (Cal.).
28327 U.S. 161, at p. 167; Ballantine in his work on Corporations (1946),
at pp. 343-344, describes the shareholder’s suit as combining two causes of
action: (1) a right in equity to compel the assertion of (2) a corporate right
when the management refuges to act.
29 354 U.S. 99 (1957).
30 Goldstein v. Groesbeck, 142 F. 2d 422, (C.A. 2 N.Y.), cet. den. 323 U.S.
737; Martin v. D.B. Martin Co., 88 A. 612 (Del. Chancery), 102 A.
7S.
31 Busch v. Mary Riddle Co., 283 F. 443
(D.C. Del.).
McGILL LAW JOURNAL
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a second corporation may maintain a derivative action for wrongs
to the second corporation where it appears that neither corporation
is willing to enforce the right of action. The reason given to justify
these “double derivative suits” is that the loss will ultimately be
sustained by the shareholders through the depreciation of stock.
The scope of these suits has however been limited to cases where
the relationship between the companies is that of holding and operat-
3
ing companies 32 or where a parent owns and controls a subsidiary ‘
though the subsidiary need not be wholly owned.3
Conclusion
At this stage, it does not seem necessary for the purposes of this
article to dwell further upon the procedural aspects of the derivative
suits. In conclusion, the position of directors may thus be described
as fiduciary both to the corporation and to the body of shareholders.
But, to again borrow Justice Frankfurter’s words:
… to say that a man is a fiduciary only begins analysis; it gives direction
to further inquiry. To whom is he a fiduciary? What obligations does he
owe as a fiduciary? In what respect has he failed to discharge these
obligations? … 35
II -LIABILITY
FOR NEGLIGENCE
A- Basis of the Liability
Liability for negligence may be based upon either a common law
duty or a statutory requirement. Relatively few Americans States
(10 out of 50 in 1965)3″ have enacted statutes codifying the standard
of conduct of directors. As often happens the legislative enactment
is an outgrowth of judicial thinking. Being a fiduciary, the director
has a duty of care to the corporation and to the shareholders. He
is bound to act honestly and in good faith in the management of the
corporation. Breach of that duty will, at common law, entail personal
liability for the director. But, by which standard should this duty
be measured? Should the director account for his “culpa lat&’ only
or even his “culpa levissima!”?
32 Hirshom v. Mine Safety Appliances, 54 F. Supp. 581
S3 Breswick Co. v. Harrison Rye Realty Corp., 114 N.Y.S. 2d 25, rearg. and
(D.C. Pa.).
app. den. 1-5 N.Y.S. 2d 302, app. dism. 109 N.E. 2d 7,12.
34 Kauf man v. Wolfson, 151 N.Y.S. 2d 530.
35 S.E.C. v. Chenery Corp., 318 U.S. 80 (1943), at p. 85.
3OAdkins and Janis, Some Observations on the Liabilities of Corporate
Directors, (1964-65), 20 Bus. Law 817.
No. 2]
NOTES
The question, thus, is what constitutes negligence? As the Su-
preme Court of the United States said in the much-quoted case of
Briggs V. Spaulding:
What may be negligence in one case may not be want of ordinary care
in another, and the question of negligence
is, therefore, ultimately a
question of fact, to be determined under all the circumstances.37
B- What constitutes actionable negligence?
Various attempts have been made by the Courts to determine
the degree of negligence giving rise to liability. As Fletcher states:
In determining whether directors are liable for negligent mismanagement,
the Courts have been prone to use fine-sounding phrases in defining the
duties of directors, and then proceed to decide the case without reference
thereto –
The rules laid down being such glittering generalities that
the case could be decided either way thereunder without violating the
rules. For this reason, it is almost impossible to say that there is any
considerable conflict of opinion.8 5
1 – Failure to exercise the highest degree of care?
The Courts, though, seem to all agree that directors are not bound
to exercise the highest degree of care: directors are neither insurers
nor guarantors of the company’s success.39 This excuse for “culpa
levissima” seems to have been first stated in 1829 in Louisiana 40
and followed ever since.41
2 – Gross negligence?
Whether gross negligence should be retained as test is a more
controversial issue. At this point one should remember the caveat
issued by the Court in the Rhode Island case of Conaty v. Torghen:
There is much discussion in the cases about gross negligence which is not
defined; whether negligence is to be tested by a man’s care in his own
affairs, or only by the conduct of the average prudent man; how far the
elements of wanton and wilful misconduct are necessary.42
The Courts using the “gross negligence” standard have applied
it as meaning that want of care and attention which ordinarily
prudent men give to their affairs, or as being that “culpa lata”
which amounts to “dolus”, or as being “crassia negligenti4” -as was
held by the House of Lords in Overend & Gurney Co. Limited v.
Gibb.43 Such being the state of confusion, it is not surprising that
37 14l U.S. i182, at p. 152.
as lleteher, op. cit., n. 5, pzan
39 Cutler v. Hicks, 268 El. App. 161, at p. 178.
40 Percy v. Millandon, 18 Mwatin N.S. 68 (La.), at (p. 74.
41 See Fletcher, op. cit., n. 5, para. 1033.
42128 A. 388, -at p. 341.
4 LR. 5 (H.L.) 480, at p. 497, per Lord Hatherley, L.C.
1029, at pp. 540-541.
McGILL LAW JOURNAL
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MoraWetz 44 describes the rule of gross negligence as being at best
misleading.
Despite the absence of uniformity in the language used by the
Courts, one leading case is often referred to as an illustration of
the gross negligence rule. In the Spering’s Appeal case 45 directors
were alleged to have made improvident loans. Judge Sharwood first
proceeded to term them as mandatories:
They can only be regarded as mandatories-persons who have gratuitously
undertaken to perform certain duties, and who are therefore bound to apply
ordinary skill and diligence, but no more.
They, therefore, were only liable for “gross inattention and
negligence by which fraud has been perpetrated” but not for mis-
takes in judgment “even though they may be so gross as to appear
absurd and ridiculous”. In keeping with such a line or reasoning
the judge candidly added:
But it is evident that gentlemen selected by the stockholders from their
own body ought not to be judged by the same strict standard as the agent
or trustee of a private estate. Were such a rule applied, no gentleman
of character and responsibility would be found willing
to accept such
places.
3 – Ordinary negligence?
Less than ten years later, the New York Court of Appeals took
an opposite view in Hun v. Cary.46 The facts were almost identical
to those of the Spering case. A bank had been operating at a loss
for several years and at a time when it owed some $70,000 to its
clients and had assets of $13,000 in cash plus certain mortgages, the
directors sought to enhance the prestige of the bank and thereby
induce confidence in its financial standing with the erection of a
new bank building. For this purpose, the directors contracted on
behalf of the bank for the purchase of very expensive lots of land
for some $74,500. After various transactions the cost of the building
and the land was in the vicinity of $57,000 with a mortgage of
$30,000. The New York Court considered the Spering case but was
of the opinion that:
… like a mandatory to whom he has been likened, he is bound not only
to exercise proper care and diligence, but ordinary skill and judgment.
As he is bound to exercise ordinary skill and negligence, he cannot set
up that he does not possess them 47
441 Morawetz Corporations, paxa. 552.
45 71 Pa. 10 (1872).
4682 N.Y. 65 (1880).
47 Ibid, at p. 74.
No. 2]
NOTES
The Court went on to say that it is the duty of bank directors to:
… exercise the same degree of care and prudence that men prompted
by self-interest generally exercise in their own affairs.
The Court, concluded that in view of the precarious financial
situation of the bank, the directors’ action was:
the
… not a mere error of judgment … but it was a case of improvidence,
of reckless, unreasonable extravagance, in which the (directors) failed in
that measure of reasonable prudence, care and skill which
law
required. 48
Both the New York and the Pennsylvania Courts attempted to
clarify the standard of conduct expected of directors by resorting
to analogies of mandatories. As already seen, this approach has been
used very frequently by the Courts for the elucidation of the nature
of the director’s position. As previously noted, the accepted doctrine
and jurisprudence hold directors to be fiduciaries. This seems to be
why in most jurisdictions ordinary or reasonable care and diligence
is the test and what amounts to lack of care is a question of fact.49
According to this, directors only have to account for their “culpa
levis”. As a Montana Court said in McConnell v. Combination Mining
and Milling Co.:
[The directors], when acting within the scope of their authority, are bound
only to the exercise of good faith and the use of their best judgment in the
conduct of the business… Their duties do not make them insurers of
the property of the company, nor guarantors that the enterprise undertaken
by the corporation shall be successful and profitable.50
A statement which echoes that of the North Carolina Court can
be found in Minnis V. Sharpe:
Directors are not guarantors of Corporation’s solvency; nor are they
insurers of the honesty and integrity of the officers and agents. Not are
they required to personally supervise all the details of business trans-
actions.fi
Directors are thus required to exercise ordinary care but axe not
supposed to be overcautious: there is a wide difference between a
trustee under the Quebec Civil Code ‘and a corporate manager whose
job is chiefly to take risks. Assuming “ordinary” or “reasonable”
care and diligence as the generally accepted standard 52 one still has
to determine what is meant by these expressions.
n. 25, at p. 403, and Adkins and Janis, loc. cit., n. 36.
4sFor an analysis and a summary of this case, see Baker and Gary, op. cit.,
49 FlIetcher, op. cit., n. 5, paa. 1035, and cases cited supra.
50 31 Mont. 563, 79 P. 248. See also Bayer v. Beran, 49 N.Y.S. 2d 2.
51202 N.C. 300, 162 S.E. 606, at p. 607; see also Meadford Trust Co. v. McKnight,
292 Mass 1, 197 N.E. 649, reviewed in 16 Boston U.L.R. 736.
52 See Adkins & Janis, loc, cit., n. 36, at p. 820; Fletcher, op. cit., n. 5, para.
1036.
McGILL LAW JOURNAL
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C – Analysis of the “ordinary care,
prudence and skill” standard
The answer to this question lies not so much in the field of
corporation law as in the law of negligence. At common law, one has
to answer the question “What would the reasonable man have done
under the same or similar circumstances ?” to determine whether
ordinary care has been applied. 53 Unfortunately, the law of negli-
gence as applied to corporate managers does not present such a
clear picture. As usual the situation may be clarified by resorting
again to the Roman law classifications: should the “bonus pater-
familias” be judged “in abstracto” or “in concreto”?
1 – The “own personal affairs” qualification
In a number of jurisdictions, the directors’ conduct is appreciated
in concreto: they have to apply to the management of the corpora-
tion the same degree of care that they, being ordinarily prudent
businessmen, exercise in the management of their own personal
affairs. This subjective standard has been laid down in several
New York leading cases. In Hun v. Cary, Judge Earl wrote:
When one deposits money in a savings bank, or takes stock in a corporation,
thus divesting himself of the immediate control of his property, he expects,
and has a right to expect that the trustees or directors, who are chosen
to take his place in the management and control of his property, will
exercise ordinary care and prudence in the trust committed to them –
the same degree of care that ‘men prompted by self-interest fenerally
exercise in their own affairsf 4
Failure to use such care renders directors liable to the corpo-
ration for damages. 5 A later decision of the New York Court of
Appeals seems to have somewhat limited Judge Earl’s statement
to financial institutions. In Hanna v. Lyon, Chief Justice Parker
wrote:
The law is settled in this state that directors of monetary corporations
are held to the same degree of care that men of ordinary prudence exercise
in regard to their own affairs.5 6
The subjectivity of such a standard does not render it very
workable. A person might conceivably take much greater risks in
personsal affairs than in the affairs of others, or what a director
deems prudent might not be considered so by a court. 7 In the
53 John G. Feming, The Law of Torts, (Sydney, 1965) at p. 110.
54 Supra, n. 46.
55Kavanaugh v. Gould Trust Co., 223 N.Y. 103, 119 N.E. 237; Gerdes v.
Reynolds, 28 N.Y.S. 2d 622.
56119 N.Y, 107, 71 N.E. 778.
5 Adkins & Janis, loc. cit., n. 96.
No. 2]
NOTES
myriad of cases on the directors’ liability, we have been unable to
discover any which applied this standard. In Pennsylvania, for
instance, the Corporations Act requires the director to discharge
his ‘duties:
With that diligence, care and skill which ordinarily prudent men would
exercise under similar circumstances in their personal business affairs.5 s
2- The “ordinarily prudent man under
similar circumstances” qualification
But in the ‘leading case of Otis & Co. v. Pennsylvania Railway
Co.,59 the Court in applying Pennsylvania law reached the conclusion
that the proper test of liability is the care, skill and diligence which
the ordinary prudent man would exercise in similar circumstances.
Pointing out this discrepancy, Adkins & Janis make the following
comment:
Characterizing the standard as being that expected from an “ordinary
prudent man” seems to be a common error. The word “ordinarily” is an
adverb and it is obviously intented to modify and give added meaning
to the word “prudent” while the word “ordinary” is an adjective and used
in this context would have to describe the word “man”. When the word
“ordinary” is used, it gives the statutory standard meaning quite apart
from that obviously intended.0
The position of the Court in the Otis case appears to be very
close to that taken by a line of British locii classici. In In re Bra-
zilian Rubber Plantations and Estates Limited,,” Justice Neville,
following what had been laid down by Lord Hatherley, L.C. in
Overend & Gurney v. Gibb, 2 wrote that:
Such reasonable care must, I think, be measured by the care an ordinary
man might be expected to take in the same circumstances on his own
behalf.i3
With the objective standard, a contrario, the Court will parallel
the conduct of the director with the degree of care an ordinarily
prudent man would have exercised under similar circumstances.
This standard has been said to be a more fair and satisfactory
5s Pa. Stat. Ann. tit. 15, ipara. 2852-408.
59 61 F. Supp. 905 (E. D. Pa. 1945).
00 Adkins & Janis, loc. cit., n. 86, at p. 80, note 17.
61 [1911] I Ch. 425, fat p. 437.
62L.R. 5 (H.L.) 480.
63 This statement has been quoted with approval in In Re City Equitable
Fire Insurance Co., [.1025] 1 Ch. 407, at p. 408, per Romer, J., and in Can.
Guarantee Trust Co. V. Young, [1931] 8 D.L.R. 519, at p. 522, per MacDonald,
C.J.K.B., (Man.).
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rule.64 In effect it was adopted by the Supreme Court of the United
States in the Briggs v. Spaulding case 65 where it was held that the
degree of care required is that which ordinarily prudent and diligent
men would exercise “under similar circumstances, and in determin-
ing that, the restrictions of the statute and the usages of business
shouild be taken into account”.
This doctrine has been followed by various jurisdictions, e.g.
Arkansas, Massachusetts, Michigan, 66 and it may be said that the
Briggs case is one of the most often cited decisions in this branch
of Company Law.67 In abstracto appreciation of the ‘director’s con-
duct provides a much more flexible standard for routine affairs.
As Art. 1053 of the Quebec Civil Code, its ostensible vagueness ren-
ders it extremely workable. This advantage seems to have prompted
some States to embody this rule in their statute law (10 out of 50
jurisdictions have statutes prescribing the standard of conduct ex-
pected from directors). 8
Amusingly enough, the State whose courts laid down the “per-
sondl affairs” standard, enacted what soon became a model for the
“objective” standard: s. 717 of New York Business Corporation Law
provides that:
Directors and officers shall discharge the duties of their respective positions
in good faith and with that degree of diligence, care and skill which
ordinarily prudent men would exercise under similar circumstances in like
positions.
An echo of this may be found at s. 131 of the Ontario Business
Corporations Act,6 which provides that:
Every director and officer of a corporation shall exercise the powers and
discharge the duties of his office honestly, in good faith and in the best
interest of the corporation, and in connection therewith shall exercise the
degree of care and skill that a reasonably prudent director or officer
would exercise in comparable circumstances.
It may thus be said that the objective standard of the “ordinarily
prudent man” is becoming more and more widely accepted in statu-
tory enactments as well as in jurisdictions still governed by the
Common Law.
64H.W. Ballantine, Ballantine on Corporations, Chicago, (1027),
(Rev. Ed.),
at pp. 158-159.
65141 U.S. 162.
66Fletcher, op. cit., n. 5, para. 1038, at p. 563.
01 Ibid., at p. 564.
6s N.Y. Bus. Corp. Law, para. 717; Idaho, Michigan, Kentucky, Oklahoma,
Washington, Pennsylvania and Alabama. See: Adkins & Janis, loc. cit., n. 36,
at p. 818.
69 Supra, n. 4.
No. 2]
NOTES
3- Mistakes and errors of judgment
Since a director needs only be an “ordinarily prudent man” when
managing the corporation’s affairs, how far will he be exculpated
from liability for mistakes and errors of judgment? Mistakes of
judgment may be of fact or of law. Mistakes of law ordinarily are
mistakes pertaining to the powers of the company or of the director.
This type of mistake will be treated separately, together with the
problem of the reliance upon counsel. Apart from this particular
type of mistake, the so-called “business judgment” rule is too well
settled to admit controversy. The basis of this rule appears to be
the common sense notion that directors are only human beings
whose decision-making involves the undertaking of risks and who,
therefore, may err. As stated by Morawetz:
Directors merely undertake to make honest use of such judgment as they
possess. They do not insure the correctness of their judgment; and they
cannot be charged with the consequences of an honest error of judgment
or accidental mistake in the exercise of their discretionary powers.70
In the leading case of Litwin V. Allen,71 Shientag, J. wrote what
may be said to fairly represent the state of the law on this point:
In other words, directors are liable for negligence in the performance
of their duties. Not being insurers, directors are not liable for errors of
judgment or for mistakes while acting with reasonable skill and prudence…
But clairvoyance is not required even of a bank director. The law recognizes
that the most conservative director is not infallible, and that he will make
mistakes, but if he uses that degree of care ordinarily exercised by prudent
bankers he will be absolved from liability although his opinion may turn
out to have been mistaken and his judgment faulty.
Finally, in order to determine whether transactions approved by a
director subject him to liability for negligence, we must “look at the
facts as they existed at the time of their occurrence, not aided or enlightened
by those which subsequently take place.7 2
Thus, it may be said that directors are excused for their “honest”
mistakes. In other words, courts decline to interfere in matters of
business judgment provided that reasonable care, skill and diligence
haive, de facto, been exercised to avoid mistakes.73 In that sense, the
“business judgment rule” does not conflict with the concept of
negligence.
70 MoraWetz, op. cit., n. 44, paxa. 553.
7125 N.Y.S. 2d 667 (S.C.N.Y., 1940).
72 Purdy V. Lynch, 145 N.Y. 462, at p. 475, 40 N.E. 232, at p. 236.
73 Casey v. Woodruff, 49 N.Y.S. 2d 625; Pool v. Pool, 16 So. 2d 102 (La.
App.).
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The Otis & Co. v. Pennsylvania Railway Co. case 74 provides a
good illustration of the rule. In this case the directors of the rail-
way company decided to refund large bond issues but did not have
recourse to competitive bidding. Noteworthy is the Interstate Com-
merce Commission’s refusal to require such bidding. Though using
their honest business judgment, the directors failed to obtain the
“best possible” prices therefor and were sued on that ground. The
Court held they were not liable for failing accurately to foretell what
the bond market would absorb.
In short, as long as reasonable care has been exercised, the court
will not substitute its judgment for that of directors in matters of
purely business and economic problems. 7
D – Factors affecting the degree of care
and possible defences
How is the standard of conduct expected of directors applied in
practice? In other words, what are the factors which affect the
degree of care and which, thus, may be set up as possible defences?
Rather than endeavour to exhaust them, we shall concentrate on
those which seem to occur most frequently.
When it is said that the director shall “bestow the care and
skill”7
that an ordinarily prudent man under similar circumstances
would bestow, it implies that the degree of care will depend upon,
inter alia, the kind of corporation, the facts or knowledge available
at the time of decision-making, the provisions of charter…
That the degree of care varies according to the kind of corpo-
ration seems to be well established. This holds true especially for
banks and other monetary institutions. As Judge Earl wrote in
Hun v. Cary:
… What would be slight neglect in the care exercised in the affairs of a
turnpike corporation, or even of a manufacturing corporation, might be
gross neglect in the care exercised in the management of a savings bank
entrusted with the savings of a multitude of poor people, depending for
its life upon credit and liable to be wrecked by the breath of suspicion.77
and Judge Shientag in Litwin v. Allen:
74 61 F. Supp. 905, adf’d. 155 F. 2d 522.
75 Helfman v. American Light & Traction Co., 11 N.J. Eq. 1, 187 A. 540;
Everett V. Phillips, 288 N.Y. 228, 43 N.E. 2d 18 (C.A.N.Y., 1042); Allied
Freightways v. Cholfin, 9l N.E. 2d 765
(S.J.C. of Mass. 1950); Bates V.
Dresser, 251 U.S. 524 (U.S. S. Ct. 1920, per Holmes, J.).
76 New York Central Railroad Co. v. Lockwood, 17 Wall. 357, at pp. 382-383.
77Supra, n. 46.
No. 2]
NOTES
Undoubtedly, a director of a bank is held to stricter accountability than
the director of an ordinary business corporation3 8
As a general rule, one may conclude that being entrusted with
the funds of others entails greater responsibility for directors, what-
ever kind of corporation it may be.79
Earlier in this chapter, facts or knowledge available at the time
of decision-making have been referred to as bearing on the degree
of care. Several situations will be envisaged under this heading.
To say that a director shall not be charged with negligence on
grounds of ex post facto knowledge is not only fair but just:
A wisdom developped after an event, and having it and its consequences
as a source, is a standard no man should be judged by.80
In view of the foregoing, one may wonder whether a plea of
ignorance or good faith based on reliance on either counsel or state-
ments prepared by officers or president could succeed.
Ordinarily, a plea of ignorance of the company’s affairs would
not succeed unless such ignorance could not have been remedied by
the exercise of reasonable care.8’
Neither will, ordinarily, honesty and good faith be valid excuses.
In Mann v. Commonwealth Bond Corp. the Court stated that:
Good faith alone will not excuse them when there is lack of the proper
care, attention and circumspection in the affairs of the corporation which
is exacted of them as trustees.8 2
But when the directors relied bone fide on financial statements
produced by officers or by the President to make public announcements
respecting the financial status of the company, declared dividends,
or filed registration statements with the S.E.C. under the Securities
Act of 1933,83 they are usually absolved from liability.84 Though
some early cases had held directors liable for reliance upon erroneous
reports from officers or employees,8 5 cases of this type are very
7825 N.YjS. 2d 667 (1940 S.C.N.Y.), at p. 678.
79 See Fletcher, op. cit., n. 5, para. 1,042; as to trust companies the leading
cases iseem to be Medford Trust Co. v. McKnight, 292 Mass. 1, 167 N.E. 649,
at p. 655, and, Prudential Trust Co. v. McCarter, 211 Mass. 162, 1%1 N.E. 42.
8o Costello v. Costello, Z09 N.Y. 252, ait p. 262, 103 N.E. 148, at p. 152.
81 Dinsmore V. Jacobson, 242 Mich. 192, 218 N.W. 700.
82217 F. Supp. 815; Commercial Bank of Bay City v. Chatfield, 101 Mich.
83 Ss. a0, 11, and 12.
84 See Note, Indemnification of Directors: The Problems Posed by Federal
Securities and Antitrust Legislation, (1063), 76 Harv. L.R. 1403, at pp. 1418-19;
3 Loss, Securities Regulation, (2e Ed. 1961), at p. 1726.
641, 80 N.W. 712.
85 Cornell v. Seddinger, 237 Pa. 389
(1912); Loan Society v. Eavenson,
248 Pa. 407 (1015).
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rare in modern times since accounting techniques have greatly im-
proved and since many jurisdictions s6 have enacted provisions in-
sulating directors from such liability.
There are two types of situations where reliance upon counsel
may cause a loss to the corporation: either the directors cause the
corporation to act in what turns out to be ultra vires, or they act
or refrain from ‘acting, though in no way ultra vires, in such a
fashion as to ultimately cause a financial loss to the corporation. 87
If, for instance, the company, after taking counsel’s advice decides
not to litigate a claim, a disgruntled shareholder can sue on the
grounds of alleged loss suffered by the company. As a general
principle in this matter it may be said that whenever a bona fide
director, having exercised reasonable care in choosing competent
counsel relies upon advice of same, he will not incur liability for
mistakes of ,lay 88 or for ultra vires acts 89 or for acts falling within
his business judgment’s province, provided of course that there is
no obvious or prima facie breach of a statutory requirement.
For instance, in the case Spirt v. Bechtel,90 the directors authorized
an agreement with the Treasury Department whereby the corpo-
ration waived a claim to tax deductions for expenses incurred under
its employee stock option plan. Involved were the duty of loyalty
(since directors had adverse interests) and the duty of care. When
sued by a shareholder on behalf of the corporation, the directors
tendered as defence their counsel’s opinion as to the absence of
breach of duty of loyalty since in his opinion the company was not
entitled to the tax deduction. The court held that the directors were
entitled to rely on counsel’s advice and further that they acted
within allowable limits of business discretion in waiving what
seemed to be a doubtful claim.
In Hornstein v. Paranount Pictures Inc., 91 a disinterested direc-
tor’s decision, based on the advice of the legal member of the board,
no to sue past and present directors was held sufficient defence against
a charge of fraud.
86 See Adkins & Janis, loc. cit., n. 36, no. 52, at p. 829.
87 Baker and Cary, op. cit., n. 25, at pp. 429-430.
88 Thompson, Corporations, (3rd Ed.), para. 1382.
89 Ibid., para. 1404; Hodges v. New England Screw Co., 1 R.I. 312.
90232 F. 2d 241 (C.A. 2, 1956); See Note 66 Yale L.J. 611.
917 N.Y.S. 2d 404 (Sup. Ct. 1942), at p. 418; aff’d. 266 App. Div. 659;
41 N.Y.S. 2d 210 (1st Dept.); aff’d. 292 N.Y. 468, 55 N.E. 2d 740 (1042).
No. 2]
NOTES
But in People v. Marcus,92 directors of a safe deposit company
were advised that a transaction was legal. Charged with violation of
the Penal Law they pleaded reliance upon their counsel. The court
held that under the circumstances, “ignorantia juris non excusat.”
Illness and age can sometimes be valid defences in negligence suits.
As Chief Justice Fuller of the Supreme Court of the United States
wrote in Brigg v. Spaulding:
Invalids are permitted to indulge in the hope of recovery, and are not
called upon by reason of illness to retire at once from the affairs of this
world and confine themselves to preparation for their passage into another.9 3
This statement has been qualified in Michelsen v. Penney:
If a director’s physical condition is such as is likely to prevent attention
to duty for a considerable length of time, he should resign and make way
for another who is able to discharge the duties of the office.94
Custom and usage of business may be taken into consideration
in determining whether or not a director is liable for negligence.9 5
However, no custom or practice may render a directorship a mere
honour, void of responsibility. 6
As often happens, directorates have non-resident members.
Whether this fact may serve as excuse remains an unsettled question.
Since most cases involve bank directors, their applicability to ordinary
corporate managers is doubtful.
In Bowerman V. Hamner,9 7 the U.S. Supreme Court held that
inability to attend meetings by reason of residence at a distance
(200 miles) is no excuse for complete neglect of duty of supervision
(the bank director did not attend a single meeting in over five years).
But the case of Wallach v. Billings 98 seems to suggest a distinction
between the duties of resident and non-,resident directors. The court
referred to the provisions of the National Bank Act stating that “at
least three-fourths of the directors must have resided in the state…
in which the association is located…” 99
to imply a distinction
between resident and non-resident directors, the latter being possibly
held to a less strict accountability than the former.
92 261 N.Y. 268; 1.5 N.E. 97 (103-3).
93 14L U.S. 132, at p. 155.
94 135 F. 2d 409.
95 Fletcher, op. cit., n. 5, para. 1053.
O6Kavanaugh v. Comnwnwealth Trust Co. of New York, 223 N.Y. 103, at
p. 106, 119 N.E. 237, at p. 238.
97250 U.S. 504 (1919).
9s2177 Ill. 218, 1A5 N.E. 382 (1917), cert. den. 244 U.S. 659 (1917).
99 12 U.S.C.A. para. 72; see Fletcher, op. cit., para. 1057.
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Whatever course of action a court would take, it should be of
comfort to the director that the plaintiff still has to prove a causal
relation between the non-residence and the loss suffered by the
company.
Applied to acts of officers and codirectors the standard of reason-
able care leads to the following grounds of liability: connivence or
participation in the wrongful act,100 negligence in supervising the
corporate business, 101 negligence in the appointment of the wrong-
doer,10 2 negligence of executive committee. As a rule it may be said
that the judicial tendency is towards a stricter accountability for
directors. 03 It has, thus, been said by the Court of Appeals of New
York:
The law has no place for dummy directors.104
According to this terse statement, directors can no longer stay
away from directors’ meetings as a practice, or rely entirely upon
others to attend to the corporate business, and escape liability for
the wrongful acts of omission or commission of other directors
or officers.0 5
Directors may, however, rely upon officers: they are not insurers
of the officers’ fidelity. As stated by Fuller, C.J.U.S. in Briggs V.
Spaulding: 106
[Directors] are not insurers of the fidelity of the agents whom they have
appointed, who are not their agents but the agents of the corporation; and
they cannot be held responsible for losses resulting from the wrongful
aets or omissions of other directors or agents, unless the loss is a con-
sequence of their own neglect of duty, either for failure to supervise the
business with attention or in neglecting to use proper care in the appointment
of agents.
One remaining problem arises from the board of directors’ custom
of appointing executive committees. Though this practice is a
00 Movius V. Lee, 30 Fed. 298, at p. 307, Fletcher, op. cit., n. 5, para. 1089.
101 Fletcher, op. cit., n. 5, para. 1070; Angelus Securities Corp. v. Ball, 20
Gal. App. 2d 423, 67 P. 2d 152.
102 Scott v. Depeyster, 1 Edw. On. (N.J., 513); Loan Society of Philidelphia
v. Eavenson, 248 Pa. 4007, 94 A. 121; Roseville Trust V. Mott, 107 A. 462,
aff’d. La Monte v. Mott, 1M6 A. 269.
103 Fletcher, op. cit., n. 5, pazra. 1065.
‘0 4 Kavanaugh v. Gould, 147 App. Div. 281, at p. 289; 131 N.Y. Supp. 1059,
at p. 1064, aff’d. 223 N.Y. 103, 110 N.E. 237.
lo Michelse
v. Penney, 125 F. 2d 409, noted -in 42 Mich. L.R. 184 and in
17 So. Calif. LR. 181.
106 141L U.S. 132, at p. 147.
No. 21
NOTES
reasonable one, the caveat issued by the Court in Kavanaugh V.
Gould should remembered:
… This custom, however, does not relieve directors generally of all
responsibility … [and they have]
the right, however, ordinarily to rely
upon the vigilance of the executive committee to ascertain and report any
irregularity or improvident acts in its management.i 07
In conclusion, directors acting in good faith exercising ordinary
care, diligence and skill in the management of the company as well
as in the choice of competent counsel will, in most cases, be immune
from attack.
III- AREAS OF LIABILITY
Though the standard of conduct required from directors is usually
that of an ordinarily prudent man under similar circumstances,
some specific areas warrant a greater degree of awareness on the
part of directors.
A – Securities Transactions
When dealings in stocks occur between directors and individual
shareholders, what is the relationship between them? To answer
this question, two sets of rules have been developed: the common
law rules and the “federal corporation law” rules stemming from
the Securities and Exchange Act of 1934.
1 – The Common Law Rules
At common law, there is conflicting authority on the precise
nature of the director –
individual shareholder relationship: some
jurisdictions follow the so-called majority rule, others the Kansas
or minority rule, and an increasing number adhere to the compromise
known as the “special facts” doctrine.
It should, however, be pointed out that none of these rules would
result in prohibiting directors from dealing with their company’s
stock, as was established by the U.S. Supreme Court in S.E.C. v.
Chenery Corp.08 But, with respect to the disclosure of “inside”
information, the various rules come into play.
Under the “majority rule”, no fiduciary relationship exists
between the shareholder and the director. The Tennessee case of
Shaw v. Cole Mfg. Co. provides for a classical formulation of the rule:
107 Supra, n. 104; as leading case on the liability of directors for acts of
codirectors see Campbell v. Watson, 62 N.J. Eq. 396, 50 A. 120 (1901, per Vice
Chancellor Pitney, later J.U.S.S.C.).
108318 U.S. 80.
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… While directors occupy a trust relation to the corporation which they
the stockholder in the sale and
direct, their duty does not apply to
purchase of stock. Dealing in its own stock is not a corporate function.
In buying or selling stock directors may trade like an outsider, provided
they do not affirmatively act or speak wrongfully, or intentionally conceal
facts with reference to it. There is also the qualification that no other
relation of trust exists between the parbies.109
Needless to say, such a rule has been “criticized as a rule of
unconscionable laxity which has been condemned by almost all text
writers and commentators, as well as by a minority of the courts.” “1
A minority of the courts, led by Kansas, holds on the contrary
that directors are fiduciaries for individual stockholders with respect
to their stock. The leading case seems to be Hotchkiss v. Fischer.”‘
There, a widow in need of money had gone in advance to the annual
meeting to ascertain whether a dividend would be declared. She
had several interviews with the president who declared himself
unable to inform her and who showed her the year-end financial
statement. He explained the items on it but painted a somewhat
dark picture. As a result of these conversations, the widow sold her
stock to him at $1.25 per share. Three days later, a dividend of
$1.00 per share was declared. Faced with such a situation, the Court
used the trustee analogy to describe the director’s duties and said
that the director is under a duty to:
… Communicate to [her] all material facts in connection with the trans-
action which the [director] knows or should know.
The director must also explain the statement:
Without being analysed and interpreted the statement would convey little
information respecting financial condition to a shareholder who did not
acknowledge special competency.
The court, then, justified its draconian approach in stating that:
… Experience teaches such transactions too often result in gross fraud.
Followed by a minority of states,” 2 the Kansas rule received an
interesting comment from a Minnesota Court in Seitz v. Frey:
In many of the cases in which the minority rule was applied, it appeared
that some radical and important change in the property, condition or affairs
of the corporation, largely increasing the value of the capital stock, was
1091 77 S.W. 479; See Agatucci v. Corradi 63 N.E. 2d 630 (Ill.); Hooker
v. Midland Steel Co., 74 N.E. 445 (Ill.); Bawden v. Taylor, 98 N.E. 941
(Il.).
110 H.W. Ballantine, op. cit., n. 64, at p. 210, quoted with approval by Fletcher,
op. cit., n. 5, para. 1068, 1; see also 19 C.J.S. para. 793(b).
1111 6 Kan. 530, 16 P. 2d 531 (1,932); noted
(1933), 46 Harvard L.R. 847;
130 Kan. 933, 31 P. 2d -37 (1934); see generally a very helpful note on directors’
purchases of shares in Baker & Cary, op. cit., n. 25, at p. 558.
12 See Fletcher, op. cit., n. 5, pamra. 1068.2.
No. 2]
NOTES
i
being effected secretly or had been so effected either by the officer himself
or by others with his knowledge and concurrence, which was concealed
from the stockholders from whom he purchased. In most of these cases
the special circumstances shown would have justified the result without
applying the stringent rule governing a trustee when dealing with his
3
cestui que trust.”
The “special facts” or “special circumstances” doctrine referred
to by the above Court, has been laid down by the U.S. Supreme Court
in Strong v. Repide.n 4 Under this doctrine a, corporate officer or
director owes a limited fiduciary duty in transactions with a share-
holder involving the transfer of stock.” 5 In Strong v. Repide, Strong
was a shareholder of a company located in the Philippine Islands.
The future of this company depended almost exclusively upon an
advantageous sale of its lands to the United States Government.
Defendant Repide, a director of the company, was in charge of the
negotiations and knew they would soon be successfully completed.
Repide used an agent to buy Plaintiff’s shares through a stockholder.
Repide concealed his identity as purchaser and failed to make
any declarations as to the state of the negotiations. As a result
Strong sold his shares at about one-tenth of what they became worth
three months later when the sale to the government was completed.
Justice Peckham commented:
It is here sought to make defendant responsible for his actions, not alone
and simply in his character as a director, but because, in consideration
of all the existing circumstances above detailed, it became the duty of the
defendant, acting in good faith, to state the facts before making the
purchase. That the defendant was a director of the corporation is but
one of the facts upon which the liability is asserted, the existence of all
the others in addition making such a combination as rendered it the plain
duty of the defendant to speak. He was not only a director but he owned
three-fourths of the shares of its stock, and was, at the time of the
purchase of the stock, administrator-general of the company, with large
powers, and engaged in the negotiations which finally led to the sale
of the company’s lands …
to the Government at a price which greatly
enhanced the value of the stock… Concealing his identity when procuring
the purchase of the stock, by his agent, was in itself strong evidence of
fraud.” 06
As to what “special facts” may be, a Michigan Court in Buckley
v. Buckley said:
113 152 Minn. 1.70, 188 N.W. 266, at p. 268 (1922). As a complement see
Amen v. Black, 234 F. 2d 12 (C.A. 10, 1965), at p. 21 –
“whether we apply
the Kansas strict accountability rule.., or the less stringent rule applicable
in Illinois… equity will not condone fraudulent representations”.
114 2A U.S. 410 (1909).
n5 Fletcher, op. cit., n. 5, ,para. 1171.
161 Ibid., at p. 431.
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The special circumstances producing exceptional cases seem to be an
assured sale, merger, or other fact or condition enhancing the value of
the stock, known by the officer or officers, not known by the stockholder,
and not to be ascertained by an inspection of the books.17
In 1933, the Supreme Judicial Court of Massachussetts in Goodwin
V. Agassiz 11 greatly reduced the scope of the special facts doctrine.
In that case a mining company had shut down exploratory operations
on a property. At about the same time, an experienced geologist
formulated in writing a theory as to the possible existence of copper
deposits on the property. Directors, thereupon, bought many shares
of the company through the facilities of the Boston Stock Exchange
without revealing the geologist’s theory to the selling shareholders.
Had the Plaintiff known about it, he would not have sold his stock.
To this Chief Justice Rugg answered:
The contention that directors also occupy the position of trustees toward
individual shareholders in the corporation is plainly contrary to repeated
decisions of this court and cannot be supported.
The learned Justice, then, proceeded to apply the special facts
doctrine:
… Where a director personnaly seeks a stockholders for the purpose of
buying his share without making disclosure of material facts within his
peculiar knowledge and not within reach of the stockholder, the transaction
will be closely scrutinized and relief may be granted
in appropriate
instances.1 19
The Court, in freeing the director from liability, rested its con-
clusions on the following grounds:
1. The transactions were effected through the anonimity of a
stock exchange.
2. Disclosure of theory would have been detrimental to the
interests of another mining company in which the defendants were
directors.
3.
“Fiduciary obligations of directors ought not to be made so
onerous that men of experience and ability will be deterred from
accepting such office. Law in its sanctions is not coextensive with
morality. It cannot undertake to put all parties to every contract
on -an equality as to knowledge, experience, skill and shrewdness.”112 0
4. The Plaintiff was no novice.
117 230 Mich. 504, 202 N.W. 955, at p. 956.
ls6 N.E. 659.
119 Ibid., at pp. 660-661; The Court, in support of this contention, cited Strong
v. Repide and Allen v. Hyatt, 30 T.L.R. 444, commented supra, n. 18 in text.
120 Strong v. Repide, supra, at p. 661.
No. 2]
NOTES
5. He made no inquiries of the defendant or of other officers
of the company.12′
The foregoing seems to indicate that the special facts doctrine,
though repeatedly applied,122 appears confined to cases of virtually
face-to-face meeting between the director and the shareholder.
Aside from the three rules outlined supra, the common law
principle respecting “half-truths” may be a source of liability in
situations where directors individually buy shares from holders. As
Fleming writes:
… A half-truth may just as much be a false representation as a complete
lie. 123
Of British origin, 2 4 this principle was applied in Von Au v.
Magenheimer.125 There the Court held that if buying directors, in
negotiations with the seller, purport to speak with respect to the
affairs of the corporation, mere literal truth is not enough, where
they know undisclosed facts which, if stated, would qualify such
truth and explain apparently unfavourable conditions. 26
If, instead of dealing for himself, the director buys shares for
the corporation, is he subject to any common law duty of disclosure?
As a rule, it may be said that the director owes his fiduciary duty
primarily to the corporation and not to the selling shareholders:
… In buying the five shares that he [the director] bought for the company
his duty was to the company for which he was acting and not to the
seller of the stock.127
An exception should be made in the case of an acquisition by a
closed corporation of a substantial part of its shares. It has been
121 See further notes to this case in (1933), 47 Harvard L.R. 353, (1933), 19
Cornell L.Q. 103 and (1933), 32 Michigan L.R. 678.
122 Nichol v. Sensenbrenner, 220 Wis. 165, 263 N.W. 650 (1935); Taylor v.
Wright, 69 Cal. App. 2d 3%7, 159 P. 2d 980 (.1045) ; Broffe v. Horton, 173 F. 2d
489 (C.A. 2, 1949); see Baker & Cary, op. cit., n. 25, at p. 560; Fletcher, op. cit.,
n. 5, ara. A.l71; 19 C.J.S. para. 793; Janigan v. Taylor, 344 F. 2d 781,
(C.A. 1, 1965), at p. 784,
123 Fleming, The Law of Torts, 3rd Ed. (.1965), at pp. 599-600; Prosser,
Torts, (1941), at p. 722.
124 Tapp v. Lee, (1803), 3 Bos. & P. 367; Curtis v. Chemical and Dying Go.,
[1961] 1 K.Q. 805; Link v. Schaible, (1,961),
7 D.L.R. (2d) 461.
125 136 App. Div. 257, at pp. 260-261, -110 N.Y.S. 029
(Zd Dpt., 1908), aff’d.
memo. 19.6 N.Y. 510, 89 N.E. =14 (1909).
120 See Baker & Cary, op. cit., n. 25, at p. 561; Restat. Torts, para. 529, com. a.
1 2 7 Gladstone v. Murray Co., 14 Mass. 584, 50 N.E. 2d 958 (1043), at p.
960; see also Steven v. Hale Haas Corp., 249 Wis. 205, 23 N.W. 2d 620 (1946).
McGILL LAW JOURNAL
[Vol. 16
held 128 that if the shares are bought at a low price and if the
persons acting for the corporation hold a substantial number of
shares, the transaction is only an indirect way of benefiting the
remaining shares and disclosure is required.
Directors may also be subject to conflicting duties when authoriz-
ing or negotiating a purchase by the corporation of its own shares.
According to Baker and Cary,129 corporations making a general
offer to their shareholders to purchase their holdings forward with
the offer an amount of information equivalent to what has been termed
a “reverse” prospectus. In connection with this, it has also been
held that a company may buy its shares at private sales without a
pro rata offering to all the holders of stock of the class affected.
As stated by the Supreme Court of Delaware in Martin v. American
Potash & Chemical Corp.:
We see no sound reason why it should be held as a matter of law that
the method of reducing capital by purchasing shares at a private sale for
invoked simply because the purpose or motive
retirement may not be
of the reduction is to eliminate a substantial number of shares held by a
stockholder at odds with management policy, provided of course that the
transaction is clear of any fraud or unfairness. 130
It may thus be said that, at common law, there is a conflict of
authority as to the precise nature of the relationship between directors
and individual shareholders and hence as to the degree of disclosure.
The general trend, (if any), would, however, seem to impose a
certain duty of disclosure upon the director when he trades on his
account meeting almost face to face with the individual holder and
when the “special circumstances” exist.
2 – The Federal Corporation Law
The very year the decision in Goodwin v. Agassiz 131 was rendered,
Congress passed the first Securities Act 132 which it complemented the
following year by the Securities Exchange Act. 133 Some thirty years
128 Wood v. McLean Drug Co., 266 Ill. App. 5 (1932); MacGill V. MacGill,
109 A. 72 (119); Johnson V. Mansfield Hardwood Lumber Co., 14. F. Supp.
826 (W.D.La. 1956).
129 See Baker & Cary, op. cit., n. 25, at p. 563.
13092 A. 2d 295 (Sup. Ct. 1952), at p. 3G2; For a discussion of these problems
(1921), 19
see Note,
25 Mich. L.R. 827; Walker, (1328), 32 Yale
Mich. L.R. 698, Berle, (,9217),
L.J. 697; Laylin, (.1018), 27 Yale L.J. 731; Wilgus, (1910), 8 Mich. L.R. 267;
Ballantine, op. cit., n. 64, para. 80.
(1946), 59 Harvard L.R. 769, at pp. 775-778; Smith,
131286 Mass. 358, 186 N.E. 659 (1933).
132 19353, 73rd Congress, Sess. I, Oh. 38, hereinafter referTed to as the 1033 Act.
133 1924, 73rd Congress, Sess. II, Ch. 404, hereinaft r referred to as the 1934
No. 2]
NOTES
later, the Court of Appeals of the Third Circuit commented the
1934 Act:
That Act deals with the protection of investors, primarily stockholders.
It creates many managerial duties and liabilities unknown to common law.
It expresses federal interest in management-stockholder relationships which
theretofore had been almost exclusively the concern of the states. … As
implemented by Rule 10b-5 and Section 29(b), Section 10(b) provides
stockholders with a potent weapon for enforcement of many fiduciary
duties. It can be said fairly that the Exchange Act, of which Sections
10(b) and 29(b) are parts, constitutes far reaching federal substantive
corporation law.’ 3 4
Under this new and rapidly expanding body of law, directors are
subjected to an extended duty of disclosure and to a certain standard
of behaviour 35 with, of course, corresponding liabilities.
A- The Duty of Disclosure
The prevailing philosophy underlying the Securities Acts may
be described as one of “full, true and plain disclosure” in all the
literature pertaining to, securities: prospectuses, reports filed with
the Securities and Exchange Commission, proxy statements and even
press releases. 36 As Brandeis wrote in Other People’s Money:
Publicity is justly commended as a remedy for social and industrial diseases.
Sunlight is said to be the best of desinfectants; electric light the most
efficient policeman.13 7
The duty of disclosure is twofold: not only must every “material”
fact be disclosed but every promise must be kept. If, for instance,
the company advertises annual certified statements to shareholders,
then failure to publish this statement will entail liability for man-
agement.
The main question to be answered remains what is a material
fact since Rule 10b-5 makes it unlawful for any person:
2- To make an untrue’ statement of a material fact or to omit to state a
material necessary in order to make the statements made, in the light of
the circumstances under which they were made, not misleading.138
1 34 McClure V. Borne Chemical Co., 292 F. 2d 824, (1961), at p. 8.34.
135 Much of the following discussion
taken from Arthur Fleischer, Jr.,
Federal Corporation Law: An Assessment, (1965), 78 Harvard L.R. 1146, here-
inafter referred to “Fleischer”.
is
136 See generally Loss I, Securities Regulations, 181-128, (2 Ed. 1961).
137 1st Ed., 1914, at p. 92.
138 Rule 10b-5 was promulgated by the S.E.C. in 1942 and the sub section quoted
is identical to the operative liability clauses in s. 11 and s. 12 of the 1933′ Act
pertaining to registration, statements, prospectus and communications.
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The leading case on materiality is S.E.C. v. Texas Gulf Sulphur
Co.’39 In determining what should be the proper test of materiality,
the majority of the Court of Appeals of the Second Circuit first
stated the objectives of the act. [The act requires]
Nothing more than the disclosure of basic facts so that outsiders may
draw upon their own evaluative expertise in reaching their own investment
decisions with knowledge equal to that of insiders. 140
The Court, approving earlier decisions,’ 4′ ruled that:
The basic test of materiality..,
is whether a reasonable man would
attach importance..,
in determining his choice of action in the trans-
action in question. This, of course, encompasses any fact.., which
in
reasonable and objective contemplation might affect the value of the
corporation’s stock or securities. 1422
The Court then concludes:
Thus, material facts include not only information disclosing the earnings
and distributions of a company but also those facts which affect the
probable future of the company and those which may affect the desire
of investors to buy or sell or hold the company’s securities.148
According to this test, the following facts would be (or have
been) considered material: a significant merger, a dividend cut,'”
important changes in sales or earnings, 145 a new line of products or
a new contract.
Knowledge of a fact might not be quite enough to subject an
insider to the hardships of rule 10b-5; the fact has to be material.
In some instances it is far from easy to determine when a fact has
‘39401 F. 2d 838 (C.A. 2, Aug. 13, 1068) Docket No. 30883 p. 3587; rev’d in
part 258 F. Supp. 262, noted at 80 Harv. L.R. 468. This case was the subject of
much comment before it was decided: Fleischer, Securities Trading and Corpo-
-rate Information Practices: The Implications of the Texas Gulf Sulphur Pro-
ceeding, (1961), 51 VaL.R. 127
, at p. 1289; Kennedy & Wander, Texas Gulf
20 Bus. Law 1057; R.A. McDowell,
Sulphur: A most unusual case, (1964),
Director’s Liabilities in Securities Transactions, (1966), 22 Bus. Law 76, at
pp. 83 et s.; Whitney, Section lob-5: From Cady Roberts to Texas Gulf: Matter
of Disclosure, (1.65), 21 Bus. Law 193; Deniel B. Posner, Developments in
Federal Securities Regulations, (1066), 21 Bus. Law 703; Insider Trading in
Stocks, Symposium held in New York on Nov. 22, 1965 with J. Farmer, W.L.
Cary, A. Fleischer, T.A. Halleran, reproduced at (.1966), 21 Bus. Law 1009. The
Texas Gulf decision has been subsequently approved in Weitzen v. Kearns, 271
F. Supp. 616(S.D.N.Y., 1967), at p. 619.
Kohler v. Kohler Co., 319 F. 2d 634 (7 Circ., 1963), at p. 64.
14 oSupra, n. 139, at p. 8608.
14’ List v. Fashion Park Inc., 340 F. 2d 457 (2d Cir. 1965), at p. 462, citing
142 Supra, n. 13, at p. 3608.
143 Ibid., at p. 3609.
144 See Cady Roberts, 40 S.E.C. 011.
145 E.g., Weitzen v. Kearns, 271 F. Supp. 616 (S.D.N.Y., 1067).
No. 2]
NOTES
become material. In the Texas Gulf case the Court held that the
materiality of a fact depends on two factors. It will first depend
“at any given time upon a balancing of both the indicated probability
that the event will occur and the anticipated magnitude of the event
in the light of the totality of the company activity”. 146 The second
factor is the importance attached to the event by those who knew
about it. In such a context, proof of insider trading becomes highly
pertinent evidence. Applying these criteria to the Texas Gulf facts,
the Court came to the conclusion that the visual assay of the drill
core completed on November 12th, 1963 was a material fact, thus
reversing the finding of the Circuit Judge. In the case of a proposed
merger, the issues become difficult. For example, the Board of
Company A might decide to acquire Company B at a certain ex-
change ratio but no concrete discussions have yet taken place. What
if negotiations have started but no agreement has been reached
so far? It would seem that the line would be drawn at the moment
where some form of consensus between the two Boards has been
reached. 1 47
What are the sanctions attached to violations of the duty of
disclosure? Three main areas will be examined in answering that
question: the required reports, the discretionary reports, and non-
disclosure not related to securities transaction.
Under s. 11 of the 1933 Act, ‘directors will be responsible for
omissions or misstatements contained in the registration statement,
whether or not they sign it, unless after reasonable inquiry they
believed it adequate. Under s. 18 (a) of the 1934 Act, directors, unless
they can prove their good faith and their absence of knowledge, are
responsible for false and misleading statements filed with the S.E.C.
to any person who, in reliance upon such statement, bought or sold
stock at a price affected by the statement.
Daily practice of the securities business raises the problem of
misleading information in gratuitous reports and circulars distributed
by a company.148 In the Texas Gulf case, management was also
charged with having issued a false and misleading press release prior
to the public announcement of the ore discovery. Rule 10b-5 applies
only to statements made “in connection with the sale or purchase
of a security”. What then does this “in connection with” requirement
mean in the case of a press release? Does this mean that Rule 10b-5
146 Supra, n. 139, at p. 3609.
147 Fleischer, Symposium on “Insider Trading in Stocks”, supra, n. 1S9, at
p. 1017.
148 See Fleischer, loc. cit., n. 135, at p. 156.
McGILL LAW JOURNAL
[Vol. 16
is only violated when the purpose of the press release is “to affect
the market price of a company’s stock to the advantage of the
company or its insiders”, as contended by Judge Bonsai in the Texas
Gulf case? 149 The majority of the Court of Appeals seems to hold
different views: legislative history shows that the intent of Congress
was to outlaw any form of device which would cause reasonable
investors “to rely thereon, and, in connection therewith, so relying,
cause them to purchase or sell a corporation’s securities”.’ 0 Thus
giving a broad interpretation to the “in connection with” requirement,
the Court held that:
Rule 10b-5 is violated whenever assertions are made, as here, in a manner
,reasonably calculated
to influence the investing public, e.g., by means
of the financial media, if such assertions are false and misleading or are
so incomplete as to mislead irrespective of whether the issuance of the
release was motivated by corporate officials for ulterior purposes. It seems
clear, however, that if corporate management demonstrates that it was
diligent in ascertaining that the information it published was the whole
truth and that such diligently obtained information was disseminated in
good faith, Rule 10b-5 would not have been violated.151
This being the principle, how will it be applied in practice? To
answer this question the Court of Appeals proposes a twofold test:
the trial judge will have to decide:
1. whether the reasonable investor in the exercise of due care
would have been mislead by the press release and
2.
if yes, whether the issuance of the release resulted from a
lack of due diligence.
In a separate but concurring opinion, Judge Friendly makes an
interesting distinction between private and public suits under Rule
10b-5 (2). In his opinion, negligent misstatements are sufficient to
give rise to injunctive relief, as asked by the S.E.C. in its brief.
He adds however:
The consequences of holding that negligence in the drafting of a press
release such as that of April 12, 1964 may impose civil liability on the
corporation are frightening 5 2
To Judge Friendly, legislative history shows that Rule 10b-5 (1) &
(3) are intended to provide for civil liability but that Rule 10b-5 (2)
was only intended to afford a basis for injunctive relief and criminal
149 258 F. Supp. 262, at p. 293.
15o Supra, n. 169, at p. 3630; the minority of the court, speaking through Mr.
Justice Moore, voiced a strong dissent against this interpretation of the legis-
lative history of s. 106 and Rule 10b-5 and approved Judge Bonzal’s opinion.
11 Ibid., at p. 3634.
152 Ibid., at p. 3644.
No. 2]
NOTES
liability. Judge Friendly leaves a doubt as to whether or not “scienter”
is a necessary element in a private damage action.
The position adopted by the Court of Appeals in the Texas Gulf
case thus rejoins the policy of the New York Stock Exchange. As
stated in the New York Stock Exchange Company Manual, the
Exchange policy is to require:
Timely disclosure, to the public and to the Exchange of information which
may affect security values or influence investment decisions, and in which
stockholders, the public and the Exchange have a warrantable interest. 53
In some instances, however, sound management, in the absence
of any securities transactions, requires the news to remain secret.
Could thus a person who, because of justified non-disclosure, bought
or sold stock at an inflated or deflated price, have a right of action
under s. 10b and Rule 10b-5? It is possible to argue that management
ought to be held responsible since it has the power to disseminate
information.15 4 Though this argument does not seem to have been
tested by the Courts, M. Fleischer 55 writes:
The imposition of liability for simple non-disclosure would seem to be a
significant enough departure from state law requirements to warrant a
clear congressional directive.156
B -The
standard of behaviour
The standard of behaviour which directors and generally insiders
will be expected to observe, derives from the so-called “anti-fraud”
provisions of the Securities Acts. That the use of inside information
is basically unfair is at the root of these provisions. As a consequence
Section 16 (b) of the 1934 Act imposes an absolute liability on in-
siders for “short-swing” profits realized in the company’s stock and
section 10(b) together with Rule 10b-5 of the same Act prohibits
the use of “any manipulative or deceptive device or contrivance”
in connection with the sale or purchase of any security. Below are
examined some problems arising from Section 16(b) and Section
10(b) with Rule 10b-5.
Until recently, most of the litigation seeking to hold directors
liable for securities transactions alleged violations of s. 16(b) of
153 S. A-2, Listing Agreement-objectives of the Agreement.
‘0 H4 Ealleran, Symposium on Insider Trading in Stocks, supra, n. 1,39, at
p. 1025.
155 See Fleischer, loc. cit., n. 185, at p. 1158.
156 In this section we did not consider the liability arising from nondisclosure
of important news specifically required by the S.E.C. rules. According to leischer,
loc. cit., n. 135, the S.E.C. may compel the filing of reports but, when no securities
transactions occur, no private right of action seems to be warranted, except when
management deliberately withholds information because of the effect that dis-
closure might have on the markets.
McGILL LAW JOURNAL
[Vol. 16
the 1934 Act. The intent of this section is to provide a “crude rule
of thumb” 157 for the prevention of the use of inside information.
Short-swing profits, within a six-month period, realized by a director
on any pair of transactions shall inure to the corporation at any-
body’s request. The liability imposed by s. 16(b) is absolute; it
depends neither upon the use of insider knowledge, nor upon whether
the other party suffered any loss or damage, nor whether the other
party is the plaintiff seeking recovery on behalf of the corporation. 68
In spite of its apparent clarity, s. 16(b) is not entirely free of
doubt with respect to the meaning of “sale” or “purchase” of a
security. Thus the conversion of a convertible security (whether
debenture or preferred stock) into common stock originally construed
as a “purchase” of the common 150 is now by S.E.C. rule no longer
deemed to be a “purchase”. 100 In the same vein, Rule 16b-7 exempts
certain acquisitions and disposals of securities pursuant to mergers
or consolidations.’ 61 Whether the receipt, disposal and exercise of
stock options, warrants or stock bonuses falls within the ambit of
s. 16(b) is still unclear. 62 Reclassification of the company’s stock
157 Corcoran, Hearings before the Comm. on Banking and Currency on
S. 84, 72d Congress, 2d Sess; and S. 56 and S. 57, 73d Congress, lst and 2d
Sess., 1934, at p. 6557.
1 8 See Allan Kramer, An Examination of s. 16(b), (1965), 21 Bus. Law 183;
R. McDowell, Director’s Liabilities in Securities Transactions, (1M66),
2)2 Bus.
Law 76 at p. 80; Loss II, pp. 1037-1-122 (,2 Ed. 1961); Smolowe V. Delendo Corp.,
136 F. 2d 2M
(C.A. 2, 1943), cent. den. 820 U;S. 751 (1,943).
159Park & Tilford v. Schulte, 1,0 F. 2d 984 (C.A. 2, 1.947), cert. den. 332
U.S. 761 (1 47); Heli-Coil Corp. v. Webster, 852 F. 2d 156 (C.A. 3, 1965), noted
in Posner, Developments in Federal Securities Regulations, (1966), 21 Bus. Law
703, at p. 710; contra: Ferraiolo v. Newman, 259 F. 2d 42 (C.A. 6, 1058), cert.
den. 359 U.S. 927 (1959); Blau v. Lamb, 363 F. 2d 507 (C.A. 2, 1066), cert.
den., Jan. 11, 1967, 385 U.S. 1002; S.E.G. V. Sterling Precision Corp., 276 F.
Supp. 772 (July 7 1967), reviewing many cases on “purchase” under s.16(b).
160 Rule 16b-9, S.E.C. Release No. 34-7826, Feb. 17, 1966.
161A recent amendment provides that the exemption shall not be available
to anyone who made short-term purchases or sales other than those involved
in the merger or consolidation. It also provides that in such a case the exemption
will be unavailable only to the extent of such purchases and sales: S.E.C. Release
No. 34-8177, Oct. 10, 1967.
162 Some cases hold that such receipt is a purchase: Bleau v. Hodgkinson, 100
F. Supp. 361 (D.C.S.D.N.Y.); the S.E.C. promulgated rule 16b-3 to exempt
these stock option plans ‘but after Greene v. Dietz, 247 F. 2d 689 (C.A. 2, 1957),
71I Harv. L.R. 386, oevoked it and then re-enacted it under an amended, form,
(S.E.C. Release No. 34-7770, Dec. .23, 19.65); see also Perlman v. Timberlake,
172 F. Supp. 246 (D.C.S.D.N.Y., 1959); Rheem Manufacturing Co. V. Rhecm,
295 F. 2d 473 (C.A. 9, 1961) and R.S. Kelly and H. Green, Application of s. 16b…
to insiders’ transactions under employee stock option plans, 17 Bus. Law 402;
Phantom Stock Plans, (1963), 76 Harv. LR. 619.
No. 2]
NOTES
was held not to be a purchase since there had been full prior disclosure,
vote by the shareholders and distribution of a proxy statement.163
From this cursory analysis of section 16 (b)’s impact on directors’
behaviour, it should be remembered that, whatever the intent, the
liability for short-swing profits is absolute.’6
While both section 16(b) and 10(b) appeared on the statute books,
the remedy provided by s. 10(b) and Rule 10b-5 was, as Professor
Loss writes, “not appreciated for some years”. 65 The prohibition of
section 10(b) of the 1934 Act is subtantiIly the same as that of
s. 17 (a) of the 1933 Act, except that s. 10(b) applies to purchases
as well as to sales, rendering it unlawful for any person:
b) To use or employ, in connection with the purchase or sale of any
security registered on a national securities exchange or any security
not so registered, any manipulative or deceptive device or contrivance in
contravention of such rules or regulation as the Commission may prescribe
as necessary or appropriate in the public interest or for the protection of
the investors.
In a preceeding section,’60 Rule 10b-5 (2) has been examined in
connection with the duty of disclosure. Under the remaining sub-
sections of Rule 10b-5, it is unlawful for any person:
1-To employ any device, scheme or artifice to defraud.
3-To engage in any act, practice or course of business which operates or
would operate as a fraud or deceit upon any person …
in connection with
the purchase or sale of any security.
Such being the language of the law, one may wonder first, what
is the 10b-5 fraud, second, who may be defrauded and third, what
are the available remedies?
Fraud in this context may take numerous forms: false statements,
failure to correct a misleading impression left by a statement already
made, or not stating anything at all when there is a duty to dis-
close.’ 67 One form of fraud, however, is of special importance to
163 Roberts V. Eaton, 212 F. d 892; cert. den. 348 U.S. 827.
164In connection with this, it has been held that segregation of shares for
the purpose of matching the transactions under s. ’16(b) is not available as a
defence; Western Auto Supply Co. v. Galmble-Skogmo Inc., 348 F. 2d 786 (C.A.
8, 1965). Before leaving this subject of short-swing profits it should be noted
that a parent may not recover from subsidiary’s officer or director realizing
short-swing profit in parent’s stock: Lee National Corp. v. Segur, 281 F. Supp.
851 (D.C. Pa. M arch 26, 1968).
165 11, at p. 1424, (2d Ed., 1961).
166 Supra, text accompanying n. 139.
167 Cochran v. Channing Corporation, 31l F. Supp. 239 (S.D.N.Y., 1962), at
p. 2M3,
McGILL LAW JOURNAL
[Vol. 16
directors: in Texas Gulf, Judge Bonsal, resting his opinion on the
“special facts” doctrine of Strong v. Repide,10
ruled that:
… Trading by an insider on the basis of material undisclosed information
in violation of the statute and rule. 00
constitutes a deceptive practice
At this point, one may -ask whether liability for trading on the
basis of material undisclosed information comprises merely “face-
to-face” transactions, as was held in Goodwin V. Agassiz.17 0 In Texas
Gulf, the Court held that:
An insider’s liability for failure to disclose material information which
he uses to his own advantage in the purchase of securities extends to
purchases made on national securities exchanges as well as to purchases
in “face-to-face” transactions. 7 1
In support of this contention, Judge Bonsal quotes Cochran V.
Channing Corp.:
It is the use of inside information that gives rise to a violation of Rule
lb-5. Lack of communication between defendant and plaintiff does not
eliminate the possibility that Rule 10b-5 has been violated.172
And as noted in Cady, Roberts:
It would be anomalous indeed if the protection afforded by the anti-fraud
provisions were withdrawn from transactions effected on exchanges, primary
markets for securities transactions. 173
What should,
thus, a director do, when legitimate business
reasons require a period of non-disclosure? The answer is now
clear: he should forego any transaction. 174
It should, however, be pointed out that this should not be
construed as prohibiting insiders from possessing specialized knowl-
edge (not material though) to acquire some stock of the company:
insiders should not be penalized for their “educated guesses”. 70
In the Texas Gulf case, the Court of Appeals held that speculation
by an insider in the company’s stock is basically wrong: insiders
may buy for growth but not for speculation on a short-erm basis. 76
168 Supra, n. 115.
169 258 F. Supp. 278. This part of the opinion was left undisturbed by the
Court of Appeals of the Second Circuit Docket No. 30882, p. 8587, at pp. 3606-
3607; see Loss, pp. 1445-1478, (2d Ed., 1961).
170S upra, n. 11.9.
171 258 F. Supp. 27a; this part of the opinion was also left undisturbed by
the Court of Appeals decision; see also List v. Fashion Park Inc., 340 F. 2d 457
(C.A. 2, 1965), at pp. 461-462.
172 Supra, n. 167.
173 40 S.E.C., at p. 914.
174 Cady Roberts, 40 S.E.C., at p. 911; S.E.C. v. Texas Gulf Sulphur Co., 258
F. Sp pp. 279; Oliver v. Oliver, 118 G.A. 362, 45 S.E. M2 (,9 03), at p. 234.
170 Loss III, supra, n. 165, at p. 1463.
176 Supra, n. 139, at p. 8813.
No. 2]
NOTES
In the same vein, the Court added that “tipping” material inside
information violates Sec. 10(b) and Rule 10b-5(3).177
The question raised by the above principle is thus: when may
insiders trade? Insiders should, of course, not be permitted to “beat
the news”. Here again the Court of Appeals sets out the principle
that:
Before insiders may act upon material information, such information must
have been effectively disclosed in a manner sufficient to insure its availability
to the investing public. 178
To achieve this end, the Court suggests that the insider should
at least wait until the news has appeared on the Dow Jones broad
tape and adds in obiter that the proper waiting period should be
determined by the S.E.C.
Supposing now that a director, believing in good faith that the
news has been disseminated, trades on the basis of what is still un-
disclosed material information. Would his good faith be a defence
under Rule 10b-5? While proof of a specific intent to defraud is not
necessary either in public or in private actions, the Court of Appeals
in the Texas Gulf case required that some form of scienter be
shown 170 and concluded that the insider’s beliefs are to no avail if
they are not reasonable under the circumstances. The Court seems
thus to suggest that good faith and exercise of due care and diligence
would normally be a defence under Rule 10b-5.
In a period of justified non-disclosure, the granting of stock
options by a committee ignoring material facts to directors aware
of such facts raises an interesting question. May the directors accept
the options without disclosing the material information to the issuer?
In the Texas Gulf case, the Court of Appeals proposed what seems
to be a reasonable rule, satisfying both the corporate trust and the
requirements of sec. 10 (b) and Rule 10b-5: the director should accept
the option but “abstain from exercising it until such time as there
shall be a full disclosure and, after the full disclosure, a ratification
such as was voted here”. 8 0
Obviously, any individual buying or selling stock may be the
victim of a 10b-5 fraud, but can the corporation be defrauded by
its directors? One may immediately raise the conceptual problem
of finding how the corporation can be deceived at all when those
who manage and act for the corporation are fully aware of the
177 Ibid., at pp. 3615-3616.
178 Ibid., at p. 36118.
179 Ibid., at pp. 3620-3621.
160 Ibid., at p. 3624.
McGILL LAW JOURNAL
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situation and are in fact responsible for it.181 Though the distinction
between a 10b-5 fraud on the corporation and fraudulent mis-
management (giving rise to a cause of action under State law) has
not yet been clearly drawn, it seems established that management
can be charged with deceiving the corporation. The legal basis for
such a theory is that the issuance by a corporation of its own shares
is a “sale” to which the anti-fraud policy expressed in the federal
securities laws extends.182 A concrete example of fraud may be found
in Ruckle v. Roto American Corp.: 113 some directors of Roto Amer-
ican had caused the corporation to issue shares without disclosing
to the remaining directors material facts concerning the transaction
or the financial condition of the corporation. The Court, after rejecting
such clich6s as the directors constitute the corporation and a corpo-
ration, like any other person, cannot defraud itself, held that the
corporation had been defrauded on the ground that:
There can be no more effective way to emasculate the policies of the
federal securities laws than to deny relief solely because a fraud was
committed by a director rather than by an outsider. Denial of relief on
this basis would surely undercut the congressional determination to prevent
the public distribution of worthless securities. 8 4
The case of O’Neil v. Maytag raises the further question whether
it is sufficient for an action under Rule 10b-5 to allege a breach of one
of the director’s general fiduciary duties where such breach does not
involve deception. The Court’s answer was categoric:
At least where the duty allegedly breached is only the general duty existing
among corporate officers, directors and shareholders, no cause of action
is -stated under Rule 10b-5 unless there is an allegation of facts amounting
to deception.’ 8 5
In spite of this statement, the broad meaning imported by the
courts 186 in the word “deception” as used in Rule 10b-5 should be
181 See Shareholders’ derivative suit to enforce a corporate right of action
against directors under S.E.C. Rule 10b-5, 114 U. Pa. LR. 578; see also Fleischer,
Federal Corporation Law…, 78 Harv. I.R. 2146, at pp. 1A614 167.
182Hooper v. Mountain States Securities Corp., 282 F. 2d 195 (C.A. 5, 1960),
at pp. 200-203, cert. den. 365 U.S. 814 (1961); Pettit v. American Stock Exchange,
21.7 F. Supp. 21 (S.D.N.Y., 1983).
38339 F. 2d 24 (C.A. 2, 1964).
184 Ibid., at p. 29.
185 3,3 F. 2d 764 (C.A. 2, 1964), at p. 767.
186 In Cochran v. Channing Corp., supra, n. 167, deception took the form of
non verbal acts: reducing dividends in order to drive down the price of the corpo-
ration’s stocks. More Tecently, the Texas Gulf case held that the use of insider
knowledge is a deceptive practice with the consequence that, if some directors,
aware of a “material Iact”, withhold it from the rest of the Board, and cause
the corporation to issue stock options to its directors, those directors having
withheld the information may be found guilty of fraud on the corporation. See
Pappas v. Moss, 293 F. 2d 865 (C.A. 3, 19.68), at p. &70.
No. 2]
NOTES
remembered as source of possible exposure to shareholders’ derivative
suit under Rule 10b-5.18 7
One final question remains to be answered: what are the remedies
for violations of Section 10(b) and of Rule 10b-5? Apparently it was
not the intent of Congress to provide civil liability under Section
10(b). 188 The federal courts, however, have read Section 10(b) and
Rule 10b-5 as implying a civil right of action.8 9 Such a practice receiv-
ed implicit pprova from the Supreme Court in P.I. Case Co. v. Borak
when it was held that the Federal Courts have a duty to “be alert
to provide such remedies as are necessary to make effective the
congressional purpose”. 90 Thus, apart from the S.E.C., any victim
of a director’s deceptive practice may seek redress against him. But,
in so doing, must the plaintiff prove the common law elements of
to be allowed a civil
fraud –
recovery? This question was the subject of much writing and of
much controversy among Federal Courts and, though the answer
is by no means free from doubt, one of the latest cases in point,
Miller v. Steinbach, 92 held that:
scienter, privity and reliance 191 –
187 Loss, at p. 11764, writes: “When a corponation has a cause of action under
the Rule a stockholder may sue derivatively under the usual conditions”; Schoen-
baum v. Firstbrook, 268 F. Supp. 385 (S.D.N.Y., 1967), ait pp. 394-39,6; for a
thorough study of the liability for corporate mismanagement and for negligent
misconduct zee: Comment, Civil Liability under Section lob and Rule lob-5: A
suggestion for Replacing the Doctrine of Privity, (1965), 74 Yale L.J, 658, at
pp. 680-690.
189 See Comment, loc. cit., n. 187; Ruder, Pitfalls in
188 See, Ruder, Civil Liability under Rule lob-5: Judicial Revision of Legislative
Intent?, (1963), 57 N.W. UL.R. 627; Loss, III, (2e Ed., 11961), at pp. 1757-1,79,7.
the Development of a
Federal Law of Corporations by Implication Through Rule lOb-5, (1064), 59 N.W.
U.L.R. 185; Ruder, loc. cit., n. 188; Joseph, Civil Liability under Rule lob-5: A
Reply, (1964), 59 N.W. U.L.R. 171; Kardon v. National Gypsum, 73 F. Supp.
708 (E.D. Pa. 194q); Fischman v. Raytheon Mfg. Co., 198 F. 2d 783 (C.A. 2,
1051) ; Speed v. Transamerica Corp., 285 F. 2d 369 (C.A. 3, 1056) ; Estate Coun-
selling Service Inc. V. Merrill, Lynch, Pierce, Fenner and Smith Inc., 303 F. 2d
527 (C.A. 1,0, 1662); Kohler v. Kohler Co., 208 F. Supp. 808 (E.D. Wis. 1962),
aff’d 310 F. 2d 634 (C.A. 7, 1063).
190 377 U.S. 426 (1063), at p. 433, noted at The Supreme Court: 1963 Term,
(,1964), 78 Harv. L.R. 14, at p. 296.
191 For a moe detailed account of the common law elements of fraud see
37 C.J.S. vo Fraud, para. 3.
192268 F. Supp. 255 (S.D.N.Y., 106), at p. 2 9.
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[Vol. 16
Although plaintiff need not prove common
law fraud to prevail in a
10b-5 action,193 he must at least allege that the purchase or sale and
the fraud complained of had some interrelationship.19 4
The old ingredients of fraud, i.e. privity ’95 and knowledge that
representations are false (scienter),196 seem thus to have disappeared
from civil actions brought under Rule 10b-5; only “some inter-
relationship” between the fraud and the sale or purchase need be
proven.
The measure of damages to which a defrauded investor may be
entitled is still unclear. Professor Loss suggests that defendants
could presumably pay the injured parties the difference between
the price at the time of the transaction and the price at the time
of the judgment. 97 Usually though, the Courts tend to apply the
tort or “out-of-pocket” measure. 98 The Texas Gulf case was expected
193 Steverts V. Vowell, 343 F. 2d 974 (C.A. 10, 1965), at p. 379; Royal Air
Properties Inc. v. Smith, 312 F. 2d 210 (C.A. 9, 192), at p. 212; Ellis v. Carter,
291 F. 2d 270 (C.A. 9, 1961), at p. 274; S.E.C. v. Texas Gulf Sulphur Co.,
258 F. Supp. 277 (1966).
194Royal Air Properties Inc. v. Smith, supra, n. 193; Barnett V. Anaconda,
238 F. Supp. 766 (S.D.N.Y. 1965), (Court’s Footnote).
is explored
195 The privity requirement and its erosions
in depth in the
Comment, supra, n. 187. In summaxy, it may be said that the courts evolved
the requirement of a “semblance of -privity”, Joseph v. Farnsworth Radio &
Television Corp., 99 F. Supp. 701 (S.D.N.Y. 1951), at p. 706, aff’d. per curiam
1.98 F. 2d 883 (C.A. 2, 1952), to -the holding that pr.ivity is only “an evidentiary
fact to be considered in conjunction with other material facts in determining
whether the relationship (such as it is) between the plaintiffs and .the defendants
and the nature of the particular acts and transactions involve the duty created
by the statute”, Brown v. Bullock, 194 F. Supp. 207 (S.D.N.Y. 1961), at p.
230, quoted with approval in Cochran v. Channing Corp., 211 F. Supp. 239
(S.D.N.Y., 1962). The Texas Gulf ease goes even further in holding that the
Rule applies as well to transactions effected on national exchanges as well as
to face-to-face transactions (supra, text accompanying n. 171).
196 The Scienter element was Tequired by Judge Wyatt in Weber v. C.M.P.
Corp., 242 F. Supp. 21 (S.D.N.Y., 1965), ‘at p. 324, declining to follow Ellis
v. Carter, 291 F. 2d 270 (C.A. 9, 1901),
(noted (1965), 20 Bus. Law 595, at
p. 604,) which was cited with approval in Stevens v. Vowell, supra, n. 193; see
further the decision of the Court of Appeals on the Texas Gulf case at pp.
3620-3621, and Miller V. Steinbach, supra, n. 1,92. See also Posner, Developments
in Federal Securities Regulation, (19066), 21 Bus. Law 703, at p. 7.13 and R.
McDowell, 22 Bus. Law 76, at p. 83; Note Proof of Scienter Necessary in a
Private Suit Under S.E.C. Anti-fraud Rule, (1965), 63 Mich. L.R. 1070.
’97 III, at p. 1793, (2e Ed. 1961).
198 E.g. Estate Counselling Service Inc. V. Merrill, Lynch, Pierce, Fenner
& Smith, supra, n. 189; Kohler V. Kohler Co., 208 F. Supp. 808 (E.D. Wis.,
1962), at pp. 825-826, aff’d. 310 F. 2d 634 (C.A. 7, 196a).
No. 2]
NOTES
to shed some light on this troublesome question 199 but all it did
was conclude that:
In accordance with the agreement with the parties, the Commission may
notice a hearing to determine the remedy to be accorded with respect to
these two defendants. 200
A director may thus be held liable but, due to a “decided lack
of clarity on the appropriate measure of damages”, 20 1 he may be
unable to measure the extent of his liability!
This analysis of the director’s liabilities under the “Federal Cor-
poration Law”, seems to reveal one basic principle governing the
director’s conduct in securities transactions: “inside information”
is an asset of the entire body of stockholders and of the corporation
which directors, as fiduciaries, may not use to their own advantage.
B- Transactions Involving Corporate Control
Two basic types of transactions involving corporate control may
result in liability for a director: the sale of control and the protection
of control.
1 – The Sale of Control
As often happens, members of the board own substantial blocks
of shares. These blocks are, in most instances, likely to carry “control”
of the corporation. The question, thus, is whether a director may
sell his controlling shares at the best price he can obtain. Numerous
reasons may be given for paying a premium for control in excess
of the share value.20 2 The sale of “control” is generally coupled with
an understanding that the control-seller will resign and cause a
majority to resign seriatim from the board to facilitate or accelerate
control by the buyer.20 3
As a stockholder the director is, by the weight of authorities, free
to sell his shares at whatever price he can obtain whether or not
the same price is offered to the other stockholders. As fiduciary,
the control-selling director must ascertain that the purchaser does
19 See Kennedy & Wander, Texas Gulf Sulphur: A Most Unusual Case,
(1965), 20 Bus. Law 1057, at pp. 1072-1073; Note, (1966), 79 Harv. L.R. 468,
at P. 475.
200 258 F. Supp. 262, at p. 296.
201 D.S. Henkel, Codification-Civil Liability under the Federal Securities Laws,
in Proceedings: Conference on Codification of Federal Securities Laws, (1967),
22 Bus. Law 793, at pp. 868, 870.
202 See Andrews, Stockholder’s Right to Equal Opportunity in the Sale of
Shares, (1-965), 78 Harv. L.R. 505, at pp. 522-536.
203 Baker & Cary, op. cit., n. 25, at p. 590.
McGILL LAW JOURNAL
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not intend to loot the corporation and may not accept any premium
as compensation for his resignaftion as director. In Ferraioli v.
Cantor,24 decided on Feb. 15, 1968, Judge Bonsal wrote:
to bargain for and receive
[A] controlling shareholder may be free
a premium in the sale of controlling stock so long as the sale does not
result in injury to the corporation. 20 5
Directors have been found liable for the sale of their controlling
shares but the basis for liability is difficult to determine from the
existing case law. Several theories have been advanced but none are
entirely satisfactory since the legal nature of “control” has not
yet been elucidated.
As indicated, liability has been imposed on directors when they
knew or should have known that the purchaser intended to loot the
company. The cases usually involve an outsider who buys a controlling
block of shares in an investment company at a premium over the
market value and who, then, causes seriatim resignations on the
board to have his nominees appointed. Once control of the board has
been secured, looting of the assets is effected. 200 In these cases the
directors have been held liable to the corporation for the loss suffered
by it as well as for any premium they may have received.
According to Berle & Means:
[The power of control] is an asset which belongs only to the corporation;
and… payment for that power, if it goes anywhere, must go into the
corporate treasury.2 7
Sale of control for private profit would thus amount to a breach
of the director’s fiduciary duty to the corporation. Though this
theory was the subject of much comment among legal writers,2 08
it does not seem to have received the Courts’ sympathy. In Honigman
204 281 F. Supp. 354 (D.C.N.Y., 1057), at p. 357.
205 In support of ,this view, the Court quotes Essex Universal Corp. V. Yates,
305 F. 2d 572 (C.A. 2, 1062), Javaras, Equal Opportunity in
the Sale of
Controlling Shares: A Reply to Professor Andrews, (1965), 32 U. Chi. L.R.
420; Hill, The Sale of Controlling Shares, (1057), 70 Harv. L.R. 986.
206E.g. Bosworth v. Allen, 168 N.Y. 157, 61 N.E. 163 (1001); Gerdes V.
Reynolds, 29 N.Y.S. 2d 622 (Sup. Ct. 1041); Insuranshares Corp. v. Northern
Fiscal Corp., 35 F. Supp. 22 (E.D. Pa., 1940); see Andrews, Wc. cit., n. 202;
Hill, Wc. cit., n. 205, at pp. 989-990; Jennings, Trading in Corporate Control,
(1956), 44 Calif. L.R. 1, at pp. 8-9, 1–1; Leech, Transactions in Corporate
Control, ((1956), 104 U. Pa. L.R. 752, at pp. 812-814; Berle, ‘Control’ in Cor-
porate Law, (1058), 58 Colum. L.R. 1212.
207Berle & Means, The Modern Corporation and Private Property, (1032),
at p. 244.
2 OSSupra, n. 206.
No. 2]
NOTES
v. Green Giant Co., 20 9 the issuance of the premium stock under the
plan of reclassification to the Class A shareholders was attacked on
the theory that Class A shareholders were in effect surrendering their
control of the Green Giant Corporation and that, as fiduciaries, they
were not allowed to profit at the expense of the company and of
the Class B shareholders. The Court of Appeals rejected the plaintiff’s
contention on the ground that Professor Berle’s view rests on no
authorities and is disputed among legal writers and that no Minnesota
cases were urged in support of Berle’s thesis.
A third theory, termed by one writer “theory of disguised premium
for the Corporate product”, 210 takes its roots in the much discussed
case of Perlman v. Feldmann.21 FR&fiann was a dominant share-
holder of Newport Steel Corp., a company producing steel sheets
for sale to manufacturers of steel products. Due to the Korean war,
a steel shortage was felt which prompted the formation of a manu-
facturers’ syndicate to acquire control of steel suppliers and, inter
alia, of Newport. Feldmann sold his block of shares to the Wilport
Syndicate at a premium. Perlman, a minority shareholder of Newport,
brought a derivative action against Feldmann to compel accounting
for and restitution of the gains realized on the sale. Various
attempts 212 have been made to decipher the ratio decidendi of the
case which would appear to be summarized in the statement:
… Where a call on a corporation’s product commands an unusually large
premium, in one form or another… a fiduciary may not appropriate to
himself the value of this premium. 2 1 3
A fourth theory, the “corporate action” theory, involves a fact
pattern which reveals that the purchaser’s ulterior motive is not
the acquisition of control as such but the acquisition of the company’s
assets. Accountability for the profits was found on the basis that
the transaction had originated as a corporate opportunity to sell
its assets and that the directors-sellers had profited from their
position to effect a transaction constituting corporate action.214 The
real price was to be pooled, divided by the number of outstanding
209208 F. Supp. 754 (D.C. Minn., 1961), aff’d. 309 F. 2d 667 (C.A. 8, 1,62),
cert. den. 372 U.S. 9.41 (,1963).
21oAndrews, loc. cit., n. 242, at ,p. 513.
211219 F. 2d 173 (C.A. 2, 1955).
212 See supra, n. 206.
213 M F. 2d 1ff73, at p. M.S.
214 Baker & Gary, op. cit., n. 25, at p. 592; Commonwealth Title Ins. & Trust
Co. v. Seltzer, 227 Pa. 410 (.S.C. Pa., 1910); 76 A 77 Roby v. Dunnett, 89 F. 2d
68 (C.C.A. 10, 1,937), cert. den. 301 U.S. 706
v. California Western States Life Ins., 15 Cal. 2d 42, 98 P. 2d 49.7
Cal., 1940); comment, (1940), 29 Cal. L.R. 67.
(1’937); American Trust ‘o.
(S.C.
McGILL LAW JOURNAL
[Vol. 16
shares and the defendants were to pay to the plaintiff the difference
between this amount and the amount they received on liquidation of
the acquired company.
Under the theory of the “sale of corporate office”, courts have
found that the premium received by the controlling directors was
not only for control but for the use of their official position to cause
the corporation to adopt a course of conduct favorable to the buyer.
In the leading case of Porter V. Healy,215 the opinion does not
clearly reveal the basis for accountability; it seems to have been
rested on the theory that the price for the sale of directorship and
control of the corporation was a corporate asset to which all holders
were entitled to share pro rata. 216
In recent years those learned in the problems of the sale of control
have advocated the adoption of a rule requiring management to
transmit to stockholders any offer to purchase a substantial number
of shares at more than the current market price.217 In view of the
developments of the Federal Corporation Law, it is believed that
such a rule already exists as a result of the Courts’ interpretation
of Section 10 (b) and of Rule 10b-5. In Ferraioli v. Cantor,2181 directors
were approached to sell their controlling shares at a premium. They,
in turn, “tipped” some of their friends who, also, were able to sell
at a premium. Such a behaviour was termed “fraudulent” under
Section 10 (b) and Rule 10b-5 as taking unfair advantage of the other
stockholders.
It may thus be deduced that, beyond the various attempts made
to impose liability for the sale of controlling shares, the omnipresent
and omnipotent Rule 10b-5 has generated a duty for directors to
offer an equal opportunity to other holders of the same class when
asked to sell their controlling shares at a premium.
2- The Protection of Control
The protection of control is an area of liability which does not
involve the director qua controlling shareholder but qua corporate
manager. The question is whether management, faced with -an outside
threat, may or should use corporate funds to repurchase the corpo-
ration’s own shares in order to protect the incumbent management’s
control. Recent Delaware cases illustrate this problem.
215 244 Pa. 427; 91 A. 428 (S.C. Pa., 1914).
216 Baker & Cary, op. cit., n. 25, at p. 595; MeLure v. Law, 101 N.Y. 78,
2d 668
(C.A.N.Y., 1899); Ballantine v. Ferretti, 28 N.Y.S.
55 N.E. 388
(S.C.N.Y., 1940), at pp. 678-680.
217 Hill, loc. cit., n. 205, at p. 1038; Andrews, loc. cit., n. 202, at p. 515.
218 281 F. Supp. 354 (D.C.N.Y., Feb. 15, 1968).
No. 2]
NOTES
In Kors v. Carey,219 the directors of Lehn & Fink noticed an
unusual buying activity in the company’s stock. It was discovered that
United Whelan, one of their customers, was buying up Lehn & Fink’s
stock, potentially bidding for control. Lehn & Fink studied the
situation, called members of the Harvard Business School for advice,
and resolved to buy out United Whelan with corporate funds. In the
Court’s opinion, Whelan’s bid for control was a “clear threat” to
the company’s business and thus no charge of misconduct or abuse
of discretion against Lehn & Fink’s directors could be sustained. 22 0
In Bennett v. Propp,221 the board chairman of Noma Lites Inc.
was advised by the board chairman of Textron that he intended to
make an offer to purchase more than 50% of Noma Lites stock at
$10.00 a share. Noma Lites’ chairman who, with some directors,
owned some 20% of Noma Lites stock, caused the company to buy
for $2,000,000 of its own stock driving the price up to $13.00 from
$9.00. An emergency directors’ meeting was called on a Saturday
to allow the chairman to obtain ratification for his acts. Most of the
directors, though they were not aware of what had happened, ratified
the chairman’s action and a loan was secured at 1/30 of 1% a day
to be able to pay for the stock on the following Monday. The Court,
distinguishing the Kors case, held that corporate funds could not be
used when no actual threat to corporate policy had occurred, to perpe-
tuate control. The Court, however, absolved all the uninitiated direc-
tors who had ratified the action since, the court held, had they refused
to ratify it the corporation would have been unable to meet its
commitment and would probably have faced a costly litigation.
In Cheff V. Mathes, 22 2 the board of Holland Furnace Co. was
threatened by A. Maremont, a well-known corporate “raider”. Hol-
land’s directors had certain views regarding the sales methods of
furnaces. After a careful investigation of Maremont’s past, the
directors concluded that his methods would be detrimental to Holland.
As a result, the board decided to use Holland’s funds to purchase
Maremont’s holdings at $14.40 a share, i.e. $3.40 above the current
market price.223 Approving Kors v. Carey, the Court held that:
Similarly, if the actions of the Board were motivated by a sincere belief
that the buying out of the dissident stockholder was necessary to maintain
219158 A. 2d 136 (Ch. Del., 1960), noted in (19.60), 70 Yale L.J. 308.
220 See Adkins & Janis, loc. cit., n. 36, at p. 925; Harold Marsh, Are Directors
Trustees?, (1966), 22 Bus. Law 35, at p. 60.
221197 A. ,2d 405 (Del., 1-962).
2221,99 A. 2d 548
(S.C. Del., 1964), noted in (1965), 78 Hary. L.R. 1253.
223 Under Delaware law, 8 Del. C. para. 160, a corporation is granted statutory
power to purchase and sell shares of its own stock.
McGILL LAW JOURNAL
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what the board believed to be proper business practices, the board will
not be held liable for such decision, even though hindsight indicates the
decision was not the wisest course.22 4
The Court also held that the board was not required to prove that
Maremont’s take-over bid would be successful and subsequently
detrimental to the company but only that they had reasonable grounds
to reach such a conclusion. The Court further held that the $3.40
paid over the market price was not unreasonable since it represented
a premium for control. In summary, the directors properly exercised
their business judgment hence barring any judicial interference.
According to these cases, directors may use the corporate funds
to purchase stock if the purchase aims at the removal of a “clear
threat” to the corporate policy22 5 and when they act primarily in the
company’s interest but, corporate funds may not be used to perpetuate
control. 2 0
In view of the foregoing analysis, it is the writer’s belief that
the “power to control” is a power held in trust by the directors for
the benefit of the corporation and of the body of shareholders.
C – Conduct of Subsidiaries
Directors of parent corporations have a duty to be fair in their
dealings with their subsidiaries insofar as they affect the rights of
minority shareholders and of creditors. To answer the question of
what is “fair”, the Courts have used three main tests: the “model
contractual transaction”, the “model corporate structure” and the
“business judgment”.227
The test of the “model contractual transaction” has been frequently
used. In Pepper v. Litton, Justice Douglas laid down the rule as:
.. * Whether or not under all circumstances the transaction carries the
earmarks of an arm’s length bargain. If it does not, equity will set it
aside.228
This test ignores the reality: how can an arm’s length bargain
take place since the same group controls both corporations?
224 Supra, m 21, at fp. 554.
225The fight must, of course, be over policy and not over personality.
226 Adkins & Janis, Zoo. cit., n. 86, at p. 826; Bennett v. Propp., supra, n. 221.
227 Corporate Fiduciary Doctrine in the Context of Parent-Subsidiary Relations,
(1964), 74 Yule L.J. 338; Case v. New York Central Railroad, 243 N.Y.S. 2d
620 (1063), rev’g. 232 N.Y.S. 2d 702 (19.62); Ewen v. Peoria & E. Ry., 78 F.
Supp. 312 (S.D.N.Y. 1948, Learned Hand J.).
228S 308 U.S. 295 (1039), at p. 306-4D7.
No. 2]
NOTES
In other cases, courts have asked whether or not there was fraud
involved in the fransaction2 29 As actual fraud is extremely hard
to prove in the context of parent-subsidiary relationships, courts
have tended to use this rule to uphold challenged transactions.
In a third line of cases the emphasized notion is that of “good
faith”. This test has been particularly used when the courts dis-
approved of the defendant’s objectives, e.g. elimination of minority
shareholders.20
The inadequacies of the “model contractual transaction”
test
are revealed by the shifting of the onus of proving the fairness of
the transaction on the defendants,2 31 thus allowing the courts to
escape a sometime difficult justification of their findings.
A second test proposed was that of the “model corporate struc-
ture”. According to this test, directors are supposed to be independent
managers and shareholders presumed to be capable of exercising
effective supervision. With this prerequisite, courts have developed
a set of technical rules to test the fairness of the transaction: has
there been approval by a majority of disinterested directors? Had
the meeting a disinterested quorum? Did the shareholders ratify
the transaction ?232 The iltogism of such an approach lies in the
fact that one group controls both boards and is a majority share-
holder of both companies.
According to a third criterion directors would be exonerated from
liability if the court is satisfied that they have exercised their honest
business judgment.23 The recent Delaware case of Epstein v. Celo-
tex23 4 illustrates this rule. The Jim Walter Corp. which, through
its wholly-owned subsidiary Celotex and through others, owned 56%
of the South Shore Corporation’s stock, made a written offer to the
public holders of such stock to purchase their holdings at $35.00 a
share. Jim Walter, Celotex and South Shore had some five common
directors. Plaintiff alleged that the Jim Walter offer was made for
229 Note, loc. cit., n. 227, at p. S41; Shelly v. Dockweiler, 75 F. Supp. 11
(S.D. Cal., 1047), at p. 14; Briggs v. Scripps 56 P. 2d 877 (1936), at p. 278
230 Chelrob Iw. v. Barrett, 57 N.E. 2d 825 (1944), at p. 833; Everett v.
Phillips, 43 N.E. 2d 18 (1942) ; Austrian v. Williams, 103 F. Supp. 64 (S.D.N.Y.,
1952), at p. 75. It is -lso to be noted that practices such as “freeze-outs” of
minority interests appeax rto be much less frequent nowadays than in. the 1920’s;
see Berle, The Corporation in Modern Society, at p. 1.3, (Mason Ed., 1959).
2 31 See note, loc. cit., n. 227, at p. 343.
2 3 2 Twin-Lick Oil Co. v. Marbury, 91 U.S. 587 (1876); Parsons v. Tacoma
Smelting & Refining Co., 65 P. 765 (1,901); Gamble v. Queens County Water
Co., 125 N.Y. 9-1, 25 N.E. 201 (1990); see note, loc. cit., n. 227, at p. 345, no. 37.
233 Everett V. Phillips, supra, n. 230.
234 238 A. 2d 843 (S. Ct. Del., Feb. 15, 1068).
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the express purpose of enabling such corporation to acquire at least
90% of the outstanding capital stock of South Shore at the inade-
quate price of $35 per share and thereafter merging South Shore into
Jim Walter under the short form merger provisions of Delaware Law.
Sometime prior to the Jim Walter offer, one Crutcher had made an
offer to buy the net assets of South Shore, then worth 31.5 million
dollars, amounting to $50 a share in stock value. Jim Walter an-
nouced that it would vote against the offer before South Shore’s
Board considered the offer. The Court held that, as a rule:
… In a situation such as the one here presented, Jim Walter as a majority
stockholder of South Shore and in a position to block any proposed sale
of such corporation’s assets, owed a highex duty to the public stockholders
of such corporation. 235
The evidence disclosed that Crutcher’s proposal, were it carried
through, would effectively result in the liquidation of South Shore.
Jim Walter’s board was of the opinion “that it is in the best interest of
stockholders of South Shore to continue operation of that company
and not to sell its assets and liquidate and dissolve South Shore” 230
and consequently decided to block the sale. The Court found that,
in so doing, the directors had honestly exercised their business
judgment and held further that plaintiff had not been able to prove
the unfairness of the transaction.
As conclusion, it may be said that, as a parent stands in a fiduciary
relationship to its affiliate’s minority shareholders, 23
7 directors stand
also in a fiduciary relationship to such shareholders which relation-
ship obligates them to deal “fairly” with the subsidiary. In most
instances, this duty will be fulfilled if the directors exercise their
honest business judgment. From a practical point of view, directors
should avoid that the affairs of the subsidiary become so interwoven
with those of parent that the idea of each as a separate entity
becomes a mere legal fiction.238
D – Antitrust Violations
Directors are subject to a wide range of legal proceedings for
violations of the antitrust laws: criminal prosecutions, civil suits
235 Ibid., at p. 847.
236Resolution of the Board of Jim Walter Corp., adopted on Feb. 28, 1967.
237 Case V. N.Y. Central Railroad, supra, n. 229, at p. 628.
2 3 8 Weinert v. Kinkel, 56 N.Y.S. 2d 92; see also Douglas and Shanks, Insulation
from Liability through Subsidiary Corporations, (1929), 39 Yale L.J. 193;
Latten, Corporations, (1959), at pp. 66-82, 90-97; Ballantine, op. cit., n. 28,
at pp. 283-333; Latty, Subsidiaries and Affiliated Corporations, (1936). The
procedural aspect of double derivative suits has been considered supra, nn. 30-34,
and Baker, & Cary, op. cit., n. 25, at p. 672.
No. 2]
NOTES
by the United States for injunction or for single damages, civil suits
by businessmen for injunction and for treble damages and finally,
derivative suits by shareholders for damages allegedly caused to
the corporation by reason of the directors’ violation of the antitrust
laws. Bearing in mind the ulterior purpose of this study i.e., the
insurability of corporate managers, it will not be attempted
to
examine the criminal and injunctive remedies but analysis will be
focussed on the monetary consequences of antitrust violations.
1I-
The Legislative Background29
Section 1 of the Sherman Act 240 makes any restraint of trade
a misdemeanour punishable by fine not exceeding $50,000 and/or
imprisonment not exceeding one year. Section 2 of the Act provides
for the same penalties for monopolies.
Section 2 of the Clayton Act,241 as amended by the Robinson-
Patman Act, 42 renders price discrimination unlawful between pur-
chasers of goods of like grade and quality where substantial restraints
may result with the exception of cost-justified differences. Section
3 of that Act outlaws the sale or lease of goods on condition that
the purchaser or lessee shall not deal in the goods of a competitor
(this section embraces, inter alia, “tie-in sales” and “requirement
contracts”). Section 4, the basis for private treble damage suits,
provides that:
Any person who shall be injured in his business or property by reason
of anything forbidden in the antitrust laws may sue therefor… and shall
recover threefold the damages by him sustained, and the cost of suit,
including a reasonable attorney’s fee.
Section 5 (a) provides that any final judgment or decree rendered
in a suit on behalf of the United States may be used as prima facie
evidence of a violation of the antitrust laws in a private suit.
Section 8 of the Clayton Act prohibits interlocking directorates
and finally, section 14 provides that the corporation’s violation of
the antitrust laws shall be deemed to be also that of the individual
directors who have committed, authorized or ordered any of the
acts violating the antitrust laws. Apart from these statutes, re-
ference should also be made to the Wilson Tariff Act, to the Robinson-
Patman Act and the Federal Trade Commission Act dealing re-
spectively with combinations to restrain trade or increase prices of
239 A good .analysis of these provisions may be found in Van Oise, Understanding
the Antitrust Laws, (Rev. Ed., 1,966), at pp. 14-65.
240 15 U.S.C., Sects. 1-8.
24115 U.S.C., Sects. 12-27.
242 15 U.S.C., Sects. 18, 1Sa, lb, Z1a.
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goods imported into the United States, with the participation in
any prohibited practice and with the FTC’s power to prevent any
unfair competition. 24 3
From this cursory analysis of the legislative background, it may
be deduced that the underlying philosophy of these enactments is
the prohibition of anything that may hamper free competition. As
will be seen, the practical application of this philosophy leads to
results greatly at variance with those reached by courts interpreting
Canadian antitrust laws. 24 4
2- Single damage suits by the United States
Although the government may sue directors for actual damages
suffered to its business or property for violations of the antitrust
laws, it seems that the government will not name directors as de-
fendants unless it appears that the company may be unable to
satisfy the judgment.24
3- Treble damage suits against directors
Treble damage liability of directors derives from Section 4 of
the Clayton Act which gives a right of action to any person injured
in his business or property as a result of antitrust violations. Several
problems arise under this section: what are the legal theories im-
posing liability on the director, what are the elements of a private
treble damage suit and finally, what is the effect of Section 5(a)
of the Clayton Act?
The first theory, and by far the most used, imposing liability
on the directors is based on the so-called “rule of agency”. If
directors acting for the corporation within the scope of their em-
ployment violate the antitrust laws, they are liable on the ground
that, as agents, they are liable for the torts in which they participated,
as was held in the leading cases of Kentucky-Tennessee Light &
Power Co. v. Nashville Coal, Justin Potter and Henry Fitch 240 and
Cott Beverages Corp. v. Canada Dry Ginger Ale Inc. et al.247
2 4 3 Apart from this enumeration of the basic relevent statutes, one may find
a very hMpful table of statutes having antitrust implications in the Annex
to R.N. Rooks, Personal Liabilities of Officers and Directors for Antitrust
Violations and Securities Transactions, (1096S), 18 Bus. Law 579, at pp. 607-61,1.
244 See Gosser, The Law on Competition in Canada, (1962), at pp. 215-225.
245V. Kramer, Liability of Corporate Officers and Directors under the
Antitrust Laws, (1962), 11T Bus. Law 897, at p. 898-899; R.N. Rooks, loc. cit.,
n. 243, at p. 59L
24637 F. Supp. 728 (W.D. Ky., 1941), eff’d. 126 F. 2d 12
247146 F. Supp. 300 (D. Ct. S.D.N.Y., 1956).
(C.A. 6, 1943).
No. 2]
NOTES
The second theory asserts the director’s liability upon his cor-
poration’s civil liability thus combining sections 14 and 4 of the
Clayton Act.
Under both theories the private treble damage action is con-
sidered to be an action in tort. In such suits the lack of specific
intent is no defence: “Liability is phrased instead in terms of un-
lawful consequences” said the Supreme Court in U.S. V. Griffit. 248
Good faith has consequently been held not to constitute a defence. 09
Even if they do not promote or order activities violating the antitrust
laws, directors can be charged with the acquiescence and ratification
of the illegal activities.2 50 In order to escape liability the director
must repudiate the activity once he learns of it.251
the director’s prohibited conduct –
In private treble damage suits, standing to sue has traditionally
been limited to those plaintiffs most directly injured by a violation.252
Courts have thus developed the “target area” doctrine limiting re-
covery only to those firms competing in the sector of the economy
in which the violation immediately restrained competition 5 3 To
substantiate his contentions, plaintiff must then prove a public
injury –
causing him a private
injury: the sustention of damage. Economic harm being intangible,
the measure of damage may be quite hard to determine.2 54 Proof
of the public injury is facilitated by Section 5 (a) of the Clayton Act
which provides that any final judgment or decree obtained on behalf
of the United States shall serve as prima facie evidence of an
antitrust violation in private suits. 255 It is, however, to be noted that
a plea of nolo contendere does not fall within the ambit of Section
5(a) .2 56 One writer raises the question whether it is possible to
advance a judgment of not guilty as a defence in a private suit. He
2
248 364 U.S. 100 (1048), at p. 105.
249 U.S. V. U.S. Gypsum Co., 340 U.S. 76 (1950), at p. 87.
250 Phelps Dodge Ref. Corp. v. F.T.C., 189 F. 2d 393 (C.A. 2, 1948), at p. 39,7.
251 See Krmier, Zoo. cit., n. 245, at p. 9,02, Manning, The Antitrust Laws and
the Corporate Executive’s Civil Damage Liability, (1965), 19 Vand. L.R. 1938.
2 Note, Private Treble Damage Antitrust Suits: Measure of Damage for
Destruction of All or Part of a Business, (1967), 80 Harv. L.R. 1566, at p. 1574l.
253E. Timberlake, Federal Treble Damage Antitrust Actions, para. 4.03;
Waldron v. British Petroleum Co., 231 F. Supp. 72 (S.D.N.Y., 1964), at p. 85;
Note, Standing to Sue for Treble Damages under section 4 of the Clayton Act,
(([964), 64 Colum. L.R. 570.
5
24 Note, loc. cit., n. 252, at pp. 1574-1586.
255 See Proper v. John Bene & Sons, 295 F. 729
(E.D.N.Y., 1923), at pp.
731.732.
2 5 6 See e.g. Bausch Machine Tool v. Aluminum Co. of the American, 79 F. 21
217 (C.A. 2, 1935), at p. 226.
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answers the question by the negative on the ground that the standard
of proof in criminal actions is stricter than in civil proceedings. 2 7
In view of the foregoing it may be concluded that, whatever
theory the Court elects to follow, a director acting in his repre-
sentative capacity is exposed to treble damage suits instigated by
anyone directly injured by a violation of the antitrust laws. As
indicated, the extent of such liability may be somewhat difficult to
ascertain. Courts have used two main methods of proving the lost
profits: the “before and after” method involving a comparison of
the records of profit earned by plaintiff prior to the impact of the
violation with those subsequent to it25
8 and the “yardstick” test
involving a study of the profits of companies closely comparable to
plaintiff’s.2 5 9 Proof of the damages might be quite difficult in case
of plaintiff alleging that defendant’s conduct prevented him from
entering in the market.26 0 When plaintiff has been completely driven
out of business, Courts have measured the damages by taking into
account the probable duration of future profits mitigated by profits
subsequently earned by plaintiff and the loss in market value caused
by the violation. When the violation caused only a partial destruction
of plaintiff’s business, Courts tend to analyze the profits lost on
the part injured or restrained in relation to the total performance
of the business.&20
It should be noted that plaintiff seems to have
some kind of a duty to minimize his damage either by buying sub-
stitute goods or defendant’s goods at increased cost. In Sun Cosmetic
Shoppe Inc. v. Elizabeth Arden Sales Corp.,2
2 the cosmetic shop
1
sued the manufacturer for refusal to supply him a free demonstrator
of cosmetics as it had done for other shops. Judge Learned Hand
257 See Manning, loc. cit., n. 251, at pp. 1945 et s.
258 See note, loc. cit., n. 252, at p. 1574, citing Bigelow v. RKO Radio Pictures
Inc., 327 U.S. 251 (1946); Eastman Kodak Co. v. Southern Photo Materials
Co., 2/73 U.S. 359 (1927); Central Coal & Coke Co. v. Hartman, 111 F. 96
(C.A. 8, 19o).
259 William Goldman Theatres Inc. v. Laew’s Inc., 69 F. Supp. 103 (Ed. Pa.,
1946), at p. 104, aff’d. per curiam 164 F. 2d 1021 (C.A. 3), cert. den. 334
U.S. 811 (1-948); Richfield Oil Corp. v. Karseal Corp., 271 F. 2d 709
(C.A.
9, 1959), cert. den. 361 U.S. 961 (1960): Union Carbide & Carbon Corp. V.
Nisely, 300 F. 2d 561 (C.A. 10, 1961).
262 118 F. 2d 150 (C.A. 2, 1.950).
26 0 Volasco Products Co. v. Lloyd A. Fry Roofing Co., 308 F. 2d 383 (O.A.
6, 1962), cert. den. 372 U.S. 907 (1963); Waldron v. British Petroleum, 231
F. Supp. 72
261 See note, loc. cit., n. 252, at pp. 1577-1585; Eastman Kodak Co. v. Southern
Photo Materials Co., supra, n. 258; Wolfe v. National Lead Co., 225 F. 2d
427 (C.A. 9), cert. den. 350 U.S. 915 (1955); Kiefer-Stewart Co. V. Joseph E.
Seagram & Sons, Inc., 182 F. 2d 228 (C.A. 7, 1950), rev’d. 340 U.S. 21,1 (1951).
(S.D.N.Y., 1064).
No. 2]
NOTES
held that if the loss caused to plaintiff by the diversion of customers
to shops with demonstrators was greater than the cost of employing
one, it would be plaintiff’s duty to minimize damages by seeking
one. Due to the enforcement purpose of the private treble damage
suit, it is now generally agreed that a defence that the loss has
been passed on will not be allowed. 263
Though the mandatory trebling provisions were primarily enacted
to encourage private prosecution by offering the prospect of a high
reward to offset the difficulty of proof, statistics show that they
failed to achieve this end.264 As defence of an antitrust suit is very
expensive, win or lose, the threat of these costs added to that of
a prodigious treble damage judgment caused the settlement of
in favour of the
numerous claims
plaintiff.
4-Derivative suits against directors265
(even rather dubious ones)
Directors owe a duty to use reasonable care in the management
of the company. This familiar principle has been extended to cases
in which the directors cause the corporation to suffer injury as
a result of any violation of the antitrust laws. In such cases the
directors are liable for the amount of damages sustained by the
corporation.266 The questions thus, are: what must a plaintiff prove
and what damages can he recover on behalf of the corporation?
a- Elements of the derivative antitrust suit
Plaintiff must prove three basic elements: (a) a violation of
the antitrust laws,267 (b) knowingly committed by the director,26s
and (c) causing injury to the corporation. For (a) one need only note
(198).
263 See Atlantic City Electric Co. v. General Electric Co., 226 F. Supp. 59
(S.D.N.Y., 1964), reviewing the state of the law. See also the opinion of Mr.
Justice Holmes in Southern Pacific Co. v. Darnell-Taenzer Lumber Co., 245 U.S.
5l
264 See note, loc. cit., n. 252, at p. 1568.
205 See generally a very good review of the antitrust problem in R.A. Whiting,
Antitrust and the Corporate Executive, (1961), 46 Va. L.R. n. 6 and (1962),
47 Va. L.R. n. 1; Blake, The Shareholders’ Role in Antitrust Enforcement,
.10 U. Pa. L.R. 148; Comment, Stockholders’ Remedies for Corporate
(1961),
Injury Resulting from Antitrust Violations: Derivative Antitrust Suit and
(1961), 59 Mich. L.R. 904; Stockholders’ action-
Fiduciary Duty Action,
Antitrust Laws, 36 A.L.R. 2d 1245.
26 6 See Ramsburg v. American Investment Co., 231 F. 2d 383
(C.A. 7, 1956),
at p. 339.
267 Diamond v. Davis, 263 App. Div. 68, 31 N.Y.S. 2d 582 (1st Dept., 1941).
(Sup. Ct., 1942),
265Simon v. Socony-Vacuum Oil Co., 38 N.Y.S. 2d 270
at p. 274.
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that, since derivative antitrusts suits are suits brought under state
law and not under the antitrust laws,2
9 Section 5(a) of the Clayton
Act is of no assistance to plaintiff.2 0 Element (b) leaves the door
open to a variety of common law defences: mistake of law when
the statute is ambiguous ;271 reliance upon subordinates when di-
rectors have no reason to suspect their conduct to be a violation of
antitrust laws, as expressed by the Supreme Court of Delaware:
6
… There is no duty upon the directors to install and operate a corporate
system of espionage to ferret out wrongdoing which they have no reason
to suspect exists. 272
For element
(c) plaintiff must also adduce proof of an inde-
pendent nature establishing the injury2 3
b- The measure of damages
Should the damages awarded be single or treble? It seems now
well established that only single damages can be recovered. There
are two major arguments militating in favour of this. On one hand,
stock ownership is not “business or property”27 4 hence no treble
damages can be awarded to a shareholder who suffered a loss of
value in his stock 2 75 On the other hand, recovery of treble damages
is limited to those persons who have been injured by a break-down
in the competitive system. The injury to the corporation does not
arise from a “lessening of competition” when the director’s illegal
conduct results in injury to the corporation.270 Recoverable damages
are thus single damages amounting to the fines, damages and liti-
gation expenses sustained by the corporation on account of the
director 2 77
In 1955, the Report of the Attorney-General’s Committee on
Antitrust noted that:
2 69 Meyer v. Kansas City So. Ry., 34 F. 2d 41(L (C.A. 2), cer. den. 299 U.S.
607 (1936), Manning, loc. cit., n. 261, at p. 1951.
270 Volk v. Paramount Pictures, 91 F. Supp. 902 (D. Minn., 1950), at p. 904.
271E.g., Gilbert v. Burnside, 216 N.Y.S. 2d 430 (2d Dept., 1061), at p. 432.
272E.g., Graham v. Allis-Chalmers, 182 A. 2d 328, aff’d. 188 A. 2d 125,
(Del., 1963), at p. ,30.
273 Borden v. Cohen, 231 N.Y.S. 2d 902, at p. 903.
2 74 Bookbout v. Schine Chain Theatres Inc., 253 F. 2d 293 (C.A. 2, 1958);
Peter v. Western Newspaper Union, 200 F. 2d 867, (C.A. 5, 1053), at p. 872.
2 75 Loeb V. Eastman Kodak, 183 F. 704 (C.A. 3, 1,910) ; Harrison v. Paramount
Pictures Inc., 155 F. Supp. 312
(EXD. Pa., 1953).
276 Conference of Studio Unions V. Loew’s Inc., 193 F. 2d 51, (C.A. 9, 1952),
at pp. 54-55.
277 Clayton v. Farish, 73 N.Y.S. 2d 727, at pp. 744-745.
278 At p. 349.
No. 2]
NOTES
… It may be difficult for today’s businessman to tell in advance whether
projected actions will Tun afoul of the Sherman Aet’s crninal stri c res.278
In view of our study, the same conclusion may well be inferred
from the civil damage provisions of the antitrust laws. Antitrust
litigation is extremely complex. Directors face the possibility of
substantial fines (up to $50,000), jail terms, single or treble dam-
ages and, on top of that, counsel fees somewhere between the dis-
tressing and the appalling. With the fine distinction existing between
the pursuit of justified corporate purposes and illegal behaviour,
the plight of directors is far from being enviable.
E – Tax and other special situations
1 -Tax decisions
Section 531 of the International Revenu Code provides that
corporations improperly accumulating surplus will be subject to a
heavy penalty tax. Surplus beyond the “reasonable needs of business”
(S. 537 I.R.C.) is often accumulated to relieve shareholders from
the dividends surtax. Pursuant to the imposition of such a penalty
tax, derivative suits have been instituted against directors. These
suits usually allege either that the directors were negligent in not
distributing the earnings since they knew or should have known
that such an accumulation would cause the imposition of a penalty
tax on the corporation or that they used the corporation to avoid
income tax on themselves and on shareholders who were in high
tax brackets.2 79 The latter situation occurs when one group of share-
holders is more interested in the possibility of selling out at capital
gains rates, the other group being more interested in income. One
known action was brought against directors but was settled after
a referee had filed a report in favour of the shareholder’s claim.2 0
2 – Corporate qualifications
Failure to qualify to do business in a particular state may prevent
the company from enforcing contracts in the courts of that state.
Some states impose criminal sanctions on those performing local
279 Baker & Gary, op. cit., n. 25, at p. 431; Griswold, Cases on Federal Taxation,
(6th Ed., 1966), at p. 951.
28OMahlsr v. Oishei, No. A. 79,948,
(Sup. Gt., Erie Co., N.Y.), discussed
in (1048), 61 Harv. L.R. .1058; Derivative Actions Arising from Payment of
Penalty Taxes under Section 102, (1,949), 49 Colun. L.R. 394; Caxy, Accumu-
lations Beyond the Reasonable Needs of the Business: the Dilemma of Section
102 (c), (1,47), 60 Harv. L.R. 1282, at p. 1292.
McGILL LAW JOURNAL
[Vol. 16
corporate acts for a non-domesticated corporation; some others only
impose civil liability.281
Failure to comply with statutory requirement may also entail
personal liability for directors. 29 2 In one Massachusetts case, stock
was issued to directors. One paid in cash, another did not pay at all,
and the third supplied equipment to the corporation. The state statute
provided that directors may be held jointly and severally liable for
the corporation’s debts if its stock is not fully paid. Since the
company’s charter did not mention the issuance of stock for property,
the directors were held personally liable for the corporation’s debts.28 3
3 – Corporate undertakings
When a resolution is adopted by the board, the failure to fulfill
the obligations assumed renders directors
liable. In Emmert v.
Drake,2 aa loans were made to the corporation on the express condition
that they should be repaid with the proceeds of a public sale of stock.
The board authorized the loans but the proceeds were used for some
other purpose and the company became insolvent. Creditors sued
directors who were held personally liable.
Conclusion
From our analysis of the areas of business activity warranting
special attention on the director’s part, one fundamental idea seems
to emerge. With the ever growing divorce of ownership from control,
a mounting emphasis is being placed on the fiduciary character of
the director’s position. Be it in securities transactions or in any
other of the areas studied, the standard of conduct to which directors
are and will increasingly be held, can hardly be better expressed
than through the words of Chief Judge Cardozo (as he then was) in
Meinhard v. Salmon:
Many forms of conduct permissible in a workaday world for those acting
at arm’s length, are forbidden to those bound by fiduciary ties. A trustee
is held to something stricter than the morals of the market place. Not
honesty alone, but the punctilio of an honor the most sentitive, is then
the standard of behavior. As to this there has developed a tradition that
is unbending and inveterate. Uncompromising rigidity has been the attitude
of courts of equity when petitioned to undermine the rule of undivided
2 8 1 F letcher, op. cit., vol. 17, para. 8525; Note, Failure to Domesticate, (1961),
100 U. Pa. L.R. 2=1, at p. 263.
282 Sheffield v. Nobles, 378 S.W. 2d 391
(C.C.A., Texas, 1964); Adkins &
Janis, lc. cit., n. 36, at p. 824.
2 8 3 Bay State York Co. v. Cobb, 195 N.E. 2d 328 (Mass., 1964); see also
Sharf v. Harstad, 377 P. 2d ,99
(C.A. 5, 1955).
283a 224 F.
299 (C.A. 5, 1955).
No. 2]
NOTES
loyalty by the “disintegrated erosion” of particular exceptions.2 8 4 Only
thus has the level of conduct for fiduciaries been kept at a level higher
than that trodden by the crowd. It will not consciously be lowered by
any judgment of this court.2 8 5
IV -THE
PROTECTION OF DIRECTORS
A somewhat frightening footnote of the Court appears in the
report of the Texas Gulf case:
At least 49 private actions are now pending in this court against TGS,
defendants named in the Commission’s actions, and others, arising out of
the transactions which are the subject matter of the Commission’s action.
Some 16 of these are individual actions, 31 axe said to be class actions,
is a derivative action. At least 475 persons are included as
and one
plaintiffs. While many of the complaints do not specify the damages
claimed, others, in the aggregate, claim compensatory damages in excess
of $2,8000,000 and punitive damages in excess of $77,000,000.286
Further illustrations of the necessity of protecting directors seem
superfluous. Two methods can be used to achieve protection: indem-
nification and insurance. 28 7 Both methods have to be examined in
the light of the distinction between derivative actions and third
party suits. In the former, the shareholder sues the director for a
wrong done to the corporation; in the latter, the director is sued for
acts done in his representative capacity causing tort to third parties. 288
A –
Indemnification
At the outset it should be pointed out that a director may not
be indemnified if the acted outside the scope of his employment.
An insider found guilty under Section 10 (b) for transactions on his
own account could certainly not claim his litigation expenses from
284 Wendt v. Fisher, 243 N.Y. 439, at p. 444; 159 N.E. 303, (Courts footnote).
285 249 N.Y. 458, at p. 464; 164 N.E. 545, at p. 546, (New York Court of
Appeals, Dec. 1028).
286 258 F. Supp. 262, no. 1, at p. 267.
2 8TSee generally Note, Indemnification of Directors: The Problems Posed
by Federal Securities and Antitrust Legislation, (1963), 7 6 Harv. L.R. 1403,
(hereinafter “The 1963 Note”); Washington & Bishop, Indemnifying the
Corporate Executive, (1963); J.W. Bishop, Indemnification of Corporate Di-
(hereinafter,
rectors, Officers and Employees,
Bishop I); J.W. Bishop, New Cure for an Old Ailment: Insurance against
Directors’ and Officers’ Liability, (1966), 22 Bus. Law 92, (hereinafter Bishop
II); Anderson, Directors and Officers Liability Insurance, (1065), 47 Chi. B.
Record 31; Note, Liability Insurance for Corporate Executives, (1967), 80
Harv. L.R. 648, (hereinafter, “The 1967 Not”); J.W. Bishop. Current Status
of Corporate Directors’ Right to Indemnification, (1956), 69 Harv. L.R. 1057.
(1965), 20 Bus. Law 833,
288 Bishop I, loc. cit., n. 287, at p. 834.
McGILL LAW JOURNAL
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the corporation. There are, however, some borderline cases such as
litigation arising under Section 16(b) since one could possibly argue
that the director would not have been subject to Section 16(b) had
he not been a director, the litigation arising, therefore, out of his
status as director. This particular problem does not seem to have
been resolved by the courts. 2 9
1- Derivative actions
In 1939 the’decision of the New York Supreme Court in New York
Dock Company v. McCollom 290 gave impetus to the whole field of
indemnification. After being completely successful on the merits
in a derivative suit, directors sought to recover their expenses from
the company. Judge Crouch ruled that the company, being unable
to derive any benefit from the indemnification, could not indemnify
the directors. The result of the decision was a proliferation first of
by-laws and then of amendments to the various State Corporation
Laws. Most statutes are rather closely copied from Section 122(10)
of the Delaware Corporation Law.291 This type of statute grants wide
powers to the corporation to indemnify its directors except in relation
to liability for negligence or misconduct in the performance of their
duty to the corporation. 292
Though the statutes clearly prohibit any indemnification of
directors found builty of breach of their duty to the corporation,
adjudication of breach of duty is not always possible. Lack of juris-
diction, prescription, procedural defects, settlements, are some of
the events preventing a court from reaching a decision on the merits.
Who should then assume the burden of litigation expenses? In
Essential Enterprises Corp. V. Dorsey Corp.,293 a stockholder’s suit
was compromised with court approval. The Court held that no
indemnification could be allowed because the compromise was a tacit
admission of breach of duty to the corporation. The Court admitted,
however, that such indemnification might be permissible under the
Delaware statute. This case, as well as a few others, 294 illustrates
the judicial reluctance to permit indemnification when a finding of
negligence appears from the circumstances. Two eminent writers in
289 Bishop I, loc. cit., n. 287, at p. 8935; 1963 Note, loc. cit., n. 287, at p. 1410.
29016 N.Y.S. 2d 844.
291 Bishop II, loc. cit., n. 287, at p. 97.
292The same provision is also found in S. 7,22 (a), of the N.Y. Bus. Corp.
Law.
293,182 A. 2d 647 (Del. Ch., 1962).
294 See Teren v. Howard, 322 F. 2d 949 (C.A. 9); S.E.C. v. Continental Growth
Fund, CCH Fed. Sec. L.R. para. 91, 437 p. 94,719 (S.D.N.Y., 1964).
No. 2]
NOTES
the field of indemnification, Judge Washington and Professor J.W.
Bishop, give a sensible answer to the above question. 29 5 If the
director is vindicated on the merits he ought to have a right to be
indemnified; if he is only partly guilty, he should also be reimbursed,
if possible, for the aspects of the case involving no breach of duty
on his part. If the suit is not settled on the merits, assuming there
is no payment to the corporation, he ought to be indemnified if
some impartial agency e.g. a court or perhaps, an independant out-
side-counsel, finds that in fact he is guilty of no wrong-doing to
the corporation. Another view, imposing greater hardship on directors,
has been adopted by the New York Business Corporation Law whose
Section 722(b) (1) prohibits indemnification for “amounts paid in
settling or otherwise disposing of a threatened action, or a pending
action with or without court approval.”
2 – Third party actions
is probably
A director furthering what he conceives to be the best interests
of his company may incur substantial liability to third parties,
the most
government included. Antitrust litigation
frequent type of third party suits. Not so long ago, Mir. Justice
Van Voorhis described antitrust prosecution as “an occupational
hazard to the officers and directors of large corporations, as truly
as falling from a ladder is an occupational hazard to a painter or
carpenter”. 296 The construction of Rule 10b-5 adopted by the Court
of Appeals of the Second Circuit in the Texas Gulf case 297 with
respect to press releases will not alleviate the burden placed on
directors by the Federal laws. Our analysis of the director’s liabilities
has shown that directors are subject to civil liability, including
compensatory and punitive damage liability, and to criminal pro-
ceedings resulting in fines and, of course, in all instances, irrespective
of the outcome of the case, to heavy litigation expenses.
a – Civil liability
(i) – Compensatory damage liability
The harm entailing liability upon directors may have been caused
intentionally, unintentionally or liability may be imposed without
specification of fault.
Unintentionally inflicted harm may result either from negligent
violations or from the vagueness of the “ordinarily prudent man”
295 Bishop I, loe. cit., n. 207, at p. 843.
296 Schwartz v. General Aniline & Film Corp., 112 N.Y.S. 2d 146, (Ist Dept.,
1952), at p. 150, aff’d. AW N.E. 2d 538 (1053).
297S.E.C. v. Texas Gulf Company (Aug. 13, 1968; G.A. 2), Docket No.
30,882, wev’g. in part 258 F. Supp. .262 (S.D.N.Y., 1966).
McGILL LAW JOURNAL
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standard. If, for example, the director and his counsel place a wrong
construction on the Robinson-Patman Act and that all the way up
to the Supreme Court split decisions uphold the conviction and allow
generous private treble damages, who should pay for the damages
and litigation expenses? The New York Business Corporation Law
at Section 723 (a) answers the question in permitting indemnification
for all expenses (for suit, settlement and attorney’s fees) “if such
director or officer acted, in good faith, for a purpose which he
reasonably believed to be in the best interest of the corporation
and, in addition, in the case of criminal actions or proceedings, had
no reasonable cause to believe that his conduct was unlawful”. Such
a reasonable rule seems to be approved by most commentators. 298
As a rule, liability resulting from willful violations cannot be
indemnified for obvious public policy reasons. There are, however,
some borderline cases. In actions based on Rule 10b-5, not all courts
agree on whether scienter is an essential element in private suits.
By the weight of the latest authorities, 99 knowledge of the wrong-
doing does not seem to be required in 10b-5 actions. But numerous
tax, securities, or antitrust provisions are free from doubt. Allowing
indemnification in case of flagrant violation of the law would negate
the deterrent purpose of the damages imposed.3 0 0
Should a director be indemnified when liability does not require
a showing of fault? In an action under Section 11 of the Seeurities
Act of 1933, the plaintiff need only show that his injury was caused
by a misleading registration statement. He does not have either to
allege or prove that the defendants knew or had reason to know
of the misstatement. The only defence available to directors is proof
of the exercise of reasonable care in the preparation of the statement.
As indicated, Courts tend to interpret Section 10(b) and Rule 10b-5
as providing strict liability. It has been suggested 30′ that “when
Section 10 (b) liability is incurred without fault, indemnification seems
consistent with federal policy”. With the ambiguities left by the
appeal decision in Texas Gulf regarding corporate disclosure, the
adoption of a rule similar to that of Section 723 (a) of the New York
Business Corporation Law would seem equitable. If, however, the
director is adjudged guilty of breach of his duty to the corporation,
indemnification would be precluded under state law.302
298 Bishop I, loc. cit., n. 287, at p. 844.
209 See supra, n. 196.
300 See -1967 Note, loc. cit., n. 287, at p. 656.
301 1963 Note, loc. cit., n. 287, at p. 1422.
302 Ibid.
No. 2]
NOTES
Not infrequently are settlements reached and pleas of nolo
contendere filed. In both cases, be they fines or damages, the amounts
involved are substantial. Settlements are reached for a variety of
reasons which do not necessarily involve an admission of guilt:
it might be less expensive to make a small payment than to undergo
the costs and risks of litigation.3 0 3 The fairly recent case of Koster
v. Warren 30 4 raises a rather difficult issue. Warren, the president
of Safeway Stores, engaged in practices which were termed illegal
by the Justice Department. He, of course, pleaded not guilty. The
Justice Department offered a reasonable consent decree to the
company if it would plead nolo contendere and if it could persuade
Warren to plead nolo contendere in order to spare everybody the
trouble of litigation. Warren, by then, was no longer president. From
the company’s viewpoint a consent decree was desirable to limit
civil liability. As price for changing his plea, the corporation agreed
to pay Warren’s litigation expenses and whatever fine he might
have to pay. Warren was sentenced one year suspended and fined
$75,000, which seems to suggest that his violations were rather
flagrant. If he willfully violated the law, his being indemnified is
contrary to public policy. In a shareholder’s suit challenging the
indemnification the Court held that the corporation acted reasonably
in reimbursing Warren. In Simon V. Socony-Vacuum Oil Co.,305 the
Court upheld the corporation’s indemnification of two directors who
entered pleas of nolo contendere on the ground that the peas were
beneficial to the corporation in avoiding adverse publicity resulting
from a trial and an adjudication of guilt which would have opened
the door to private treble damage actions. 30 6 These decisions have
been critized as contrary to public policy.307 Despite these decisions,
for which “the real guilt might rest with the Justice Department
for making this sort of deal”, 30
the rule laid down at Section 723 (a)
of the New York Statute should prevail30 9
303 Ibid.
304 176 F. Supp. 459 (N.D. Cal., 1,959), aff’d. 297 F. 2d 418 (C.A. 9, 1961),
Bishop I, loc cit., n. 287, at p. 842.
3058 N.Y.S. 2d 2.70 (Sup. Gt., 1942), aff’d. mere. 47 N.Y.S. ?d 589 (1944).
306 Section 5 (a) of -the Clayton Act.
307 1963 Note, loc. cit., n. 287, at p. 1425.
308 Bishop I, loc. cit., n. 287, at p. 842.
309 See supra, text accompanying n. 298. In Diamond v. Diamond, 120 N.E.
2d 819 (1954), and in People v. Uran Mining Corp., 216 N.Y.S. 2d 985 (10.1),
the directors’ misconduct was demonstrated in court but liability was avoided
on other grounds. It could thus be argued that zettlements would be indem-
nifiable except if misconduct which would be the basis for liability if adjudicated
is shown. 1963 Note, loc. cit., n. 287, at p. 1409.
MCGILL LAW JOO)RNAL
[Vol. 16
(ii)- Punitive damage liability
Since in most jurisdictions the purpose of punitive damages is
penal rather than compensatory,3 10 it would seem clearly unlawful
to indemnify directors for this type of damage. One problem is raised
by treble damages: are the extra two-thirds of liability punitive or
compensatory? Three theories have been advanced. One writer 31 ‘
argues that the trebling is intended to compensate the plaintiff for
unprovable injuries. One Court held that the remedy had a prima-
rily punitive objective. 12 Another Court was of the opinion that the
purpose of treble damages was to provide an incentive to injured
persons to litigate their grievances.3 13 The latter view, promoting
both deterrent ‘and compensatory purposes, appears to be the most
consistent with the enacting intent.314
b – Criminal liability
Generally public policy would forbid indemnification for criminal
fines and penalties since it would undermine the purpose of the law.
It has, however, been pointed out earlier in this chapter that some
laws impose strict criminal liability. In the light of the statement
of the Attorney-General’s Committee on Antitrust to the effect that
it is sometimes impossible to draw a clear line between the further-
ance of legitimate corporate interests and violations of the law,815
the New York rule of Section 723 (a) seems reasonable.
c – Litigation expenses
Several arguments have been advanced against indemnification
of the litigation expenses. It may be argued, for instance, that a
defendant, who might have otherwise settled, may be encouraged
to litigate, thus inflicting undue delays and expenses on the plaintiff.
Conclusive arguments favouring indemnification, even in case of
criminal proceedings, may be advanced. First, the possibility of being
able to fully defend oneself should not be jeopardized by the fear
of substantial counsel fees. Second, defendant’s liability should not
be aggravated by legal fees. Third, not all claims require the same
amount of work: legal fees vary rather according to the difficulty of
3101967 Note, Zoo. cit., n. 287, at p. 659; Note, Exemplary Damages in the
Law of Torts, (1957), 70 Harv. L.R. 617, at pp. 520-521.
311 Void., Are Threefold Damages Under the Antitrust Act Penal or Com-
pensatory?, (1040), 28 Ky. L.J. 117.
312 Commissioner v. Obear-Nester Glass Co., 2117 F. 2d 56 (C.A. 7, 1954), at
pp. 01-62, cert. den. 348 U.S. 982.
313 Julius M. Ames Co. v. Bostitich Inc., 240 F. Supp. 521 (S.D.N.Y., 1965),
at p. 525.
314 See Manning, loc. cit., n. 252, at p. 1568.
315 Supra, n. 278.
No. 2]
NOTES
the defence than to the degree of misbehaviour. 16 It has been shown,
for example, that the average person pleading nolo contendere was
fined approximately $7,400 and a person pleading not guilty ap-
proximately $13,700. 317 It is thus agreed among most writers that
litigation expenses ought to be indemnifiable when the director acted
in his representative capacity.31 s
B –
Insurance
Two types of insurance policies are on the market: insurance
purchased by the director and insurance purchased by the corpo-
ration either to protect itself or its management 3 19
1 –
Insurance purchased by the director
At the outset it should be examined whether this insurance is
liability or indemnity insurance. Despite a somewhat faulty drafts-
manship in existing policies 3 20 it seems generally agreed that the
nature of this type of coverage is liability insurance rather than
indemnity.32′
According to those learned in this field, it appears that a director
is able to obtain coverage for compensatory liability, including settle-
ments, with, however, some doubts as to whether liability for in-
tentionally inflicted harm is covered in the “dishonesty” exclusion
found in most policies.3 22 Coverage for this type of loss has been
objected to on grounds of public policy.3 23 One could conceivably
argue that insurance is usually not available for losses depending
upon the insured’s volition. With respect to punitive damages
liability, it has been argued that insurance covering such damages
is contrary to public policy. A majority of courts, however, upholds
this type of insurance in saying that the insured pays a premium
commensurate with the insurer’s assumption of that added risk.324
316 1063 Note, loc. cit., n. 2987, at p. 141.l
317 Adkins & Janis, loc. cit., n. 36, at p. 823; Note, (1963), 76 Harv. L.R. 579,
at P. 583.
at pp. 661, 663.
3181063 Note, loc. cit., n. 287, at pp. 141114412; 1067 Note, loc. cit., n. 287,
810 Much of what follows is taken from the 1967 Note.
3 2 0 See Lloyd’s Directors and Officers Form, yara. 2(c).
321 See 1967 Note, loc. cit., n. 287, at p. 652; Bishop II,
loc. cit., n. 287, at
p. 108.
322 Bishop II, loc. cit., n. 287, at no. 44.
323 1967 Note, loo. cit., n. 287, at p. 656.
324 Carroway v. Johnson, 139 S.E. 2d !08
Underwriters Ins. Co., 383 S.W. 2d 1
National Casualty Co. v. McNulty, 307 F. 2d 432 (C.A. 5, 1,96).
(S.C., 1065); Lazenby v. Universal
(Tenn., 1964), contra Northwestern
McGILL LAW JOURNAL
[Vol. 16
Most insurance policies cover also criminal proceedings 326 but exclude
“fines or penalties imposed by law”.
In any event, it seems that purchase of insurance against third
party liability should be permitted. Professor Bishop argues soundly
that “whatever harm to public policy is implicit in freeing him from
fear of a fairly unlikely consequence of his crime is outweighed by
additional protection to the innocent victim”.3 20
Could a director purchase insurance covering his liability to the
corporation? The standard of care to which he is bound seems so
vague that he should, in all fairness, be able to protect himself from
ordinary negligence short of willfulness.327 In essentio, such an in-
surance would be analagous to the lawyer’s or doctor’s liability
insurance for malpractice.
2-
Insurance protecting the corporation
Insurance purchased by the Corporation
a-
There seems to be no reason why a corporation should not be able
to insure itself against loss caused by the directors’ breach of duty.
Such insurance, as Bishop points out,328 is similar to the ordinary
fidelity bond affording protection against agents’ embezzlements.
Another type of coverage is being presently offered to corpo-
rations: reimbursement of any sum which the company properly
pays to a director (or executive) by way of indemnification. The
board has the power to control the extent of the losses covered by
the reimbursement poliey in cases in which it has discretion whether
or not to indemnify a director. It could be argued that insurance
could have the undesirable effect of inducing management to resolve
borderline cases in favour of indemnification. 21 Conversely, it may
be said that:
… By protecting executives who might otherwise not have received indemnity
solely because of the financial burden of reimbursement, such insurance
helps to enable the corporation, at relatively little cost, to attract and retain
competent personnel.330
b –
Due to the lack of reliable statistics, the practice of insurance
companies has been to sell one policy covering the entire board. Is
the use of corporate funds to purchase such insurance justifiable?
Insurance protecting the directors
325 Ameican Home policy, Lloyd’s Form; Bishop II, loc. cit., n. 287, no. 66.
326 Bishop II, loc. cit., n. 287, at p. 109.
327 See 1967 Note, loc. cit., n. 287, at p. 654.
328 Bishop II, loc. cit., n. 287, at p. 110.
329 1067 Note, loc. cit., n. 297, at p. 664.
330 1967 Note, loc. cit., n. 287, at p. 665.
No. 2]
NOTES
third party actions
i-
Whenever indemnification is permissible, it would seem that the
company may purchase insurance for its directors. Such insurance
may be viewed either as a form of indemnification or as a part of
the compensation for services rendered. 31 A company could not, of
course, indemnify or insure a director against the penal consequences
of deliberate wrongdoing done within
–
the scope of his employment.33 2 To determine the validity of such
a purchase, Washington and Rothschild 333 propose to examine the
good faith of the directors in authorizing the purchase and not the
amount involved, especially if the corporation is publicly held.
fines and prison terms –
ii – Shareholders’ derivative actions
It can easily be argued that the corporation’s purchase of in-
surance covering the director’s branch of duty to the corporation
reduces the amount of the company’s eventual recovery by the amount
of the premium previously paid.3 34 Arguments to the effect that a
lowering of the degree of care exercised by the directors would
ensue do not seem particularly persuasive. In any event, share-
holders suits challenging the propriety of the payment of premiums
appear unlikely since the amounts involved are too small to arouse
the interest of a lawyer seeking a substantial contingent fee.
Conclusion
In view of the foregoing study, it may be said that the most
efficient way to protect directors is insurance purchased by the
corporation. Professor Bishop argues that such a purchase might
be against public policy and, consequently, policies protecting
directors should be paid for by the directors but he admits that his
views are neither supported nor contradicted by authority.3 35 Another
writer contends that Bishop makes an “unsound identification of
insurance with indemnification” and adds that:
331 It has been pointed out (1967 Note, loc. cit., n. 287, at p. 667) that a
three-year policy with a $5,000,000 limit would cost at most $50,000 or some
$17,000 per year. Since the allocation is usually 90%-14% between the corporation
and the directors (see Anderson, (1965), 47 Chi. B.Rec. 31, at p. 32), the yearly
cost per individual would be something less than $1700 divided by the number
of insured.
332 Bishop II, loc. cit., n. 287, at p. 107.
333 Compensating the Corporate Executive, (3rd Ed., 1062), at pp. 923-924.
334 Bishop II, loc. cit., n. 287, at pp. 104, 106; 1967 Note, loc. cit., n. 287, at
p. 667.
335 Bishop II, bc. cit., n. 287, at pp. 111-112.
McGILL LAW JOURNAL
[(Vol. 16
So long as the purchase of insurance can be justified simply as compensation,
as would almost always be the case, such expenditures would seem
unobjectionable.X3 0
Whichever view will prevail is difficult to foretell: it will mostly
depend upon the wording of future policies and their judicial con-
struction.
CONCLUSION
Reinforcement of the director’s fiduciary character has already
been brought to light. Various devices used to protect directors from
the hardship of liability have been examined. Beyond the law, taught
Professor Berle at Columbia Law School,337 there is the field of
inchoate law affecting corporations holding market power, or on
which the community has come
to depend for some essential
function. Corporate managers operate in “that no man’s land where
law, economics and political science meet, and where new law is
daily cristallizing”. 38 Thus, if directors adopt a course of conduct
which, though legal from the technical standpoint, violates the
ordinary standards of the community, state intervention is soon
predictable. This intervention will, in most cases, not only remedy
the situation but will also tighten the existing body of law. Two
examples clearly illustrate this theory. In April 1962, American
steel corporations pushed price administration into a dangerous area,
not only were they the object of political action but also of antitrust
39 In Canada, two major bank-
and various other investigations.
ruptcies –
those of the Alliance Corporation and of the Prudential
and a gigantic stock swindle 340 prompted the Govern-
Corporation –
ment of Ontario to appoint a Committee 341 whose far-reaching
recommendations were enacted in 1966. In conclusion, corporate
directors should not only base their decisions on what the law is
but also on what the community thinks is fair. History shows that
the community’s standard of fairness usually becomes the law; it
is thus the lawyer’s duty of clairvoyance to perceive this standard.
Pierre-FMix DE RAVEL D’ESCLAPON 0
336 1967 Note, loc. cit., n. 287, at p. 669.
337Book Review, (,1,962),
338 Ibid., at p. 431.
339 Eerle, loc. cit., n. 337.
340 See Report on Windfall Oil & Mines Ltd., (The “Kelly Report”), disclosing
745 Harv. L.R. 430, at p. 432.
the abuses of insider trading, Ontario Securities Commission.
341Attorney General’s Committee on Seeurities Legislation, (1965),
(The
Kimber Report), Ontario.
New York City.
* DL.L. (U. de M.), LL.M. (Harvard); presently registered law clerk in
