DUTIES OF DIRECTORS AND CONTROLLING STOCKHOLDERS FACTS
DUTY OF DILIGENCE: BUSINESS JUDGEMENTS RULE 1. Petitioner Otis & Co. ("Otis") is a stockholder in the Pennsylvania Railroad Co. ("PRR")
61 F. Supp. 905 (E.D. Pa. 1945) - Otis & Co. v. Pennsylvania R. Co.
KALODNER, District Judge
SUMMARY
Petitioner Otis & Co. ("Otis") is a stockholder of respondent Pennsylvania Railroad Co.
("PRR"). PRR thought that it would be a good idea to refinance its current outstanding bonds
(Series A bonds) through selling new bonds, the Series D bonds, at the best obtainable
price. Due to this, Otis brought a derivative suit against PRR, seeking to hold liable PRR's
officers and directors as well as to hold liable the officers and directors of Pennsylvania,
Ohio and Detroit Railroad Co. ("POD"), a wholly-owned subsidiary of PRR.
Otis claims that the companies and its directors failed and refused to exercise ordinary care
and judgement in the sale of the Series D bonds as PRR and POD kept secret the bond
issue and refused to deal with any investment house other than Kuhn, Loeb & Co. ("KLC").
Otis claims that the companies should have opened the bond issue to other players through
competitive bidding and alleged that some directors could have been influenced by their
positions (also as directors) in several institutions which had agreements with KLC.
The District Court here held that using the "business judgement rule" ("BJR") it is clear that
the officers and directors of PRR and POD acted honestly and in good faith and merely
exercised their judgement for the best interests of the railroads. There is no requirement
under the law that they are to subject the issue of the bonds to competitive bidding. Not
doing so is well within their discretion and they had the right to negotiate privately with KLC,
a firm which they had the confidence of years of satisfactory banking relations which was
well acquainted with their financial situation.
DOCTRINE
Officers and directors shall be deemed to stand in a fiduciary relation to the corporation, and
shall discharge the duties of their respective positions in good faith and with that diligence,
care and skill which ordinarily prudent men would exercise under similar circumstances in
their personal business affairs.
the courts say that they will not interfere in matters of business judgment, it is presupposed
that reasonable diligence has in fact been exercised. A director cannot close his eyes to
what is going on about him in the conduct of the business of the corporation and have it said
that he is exercising business judgment. Courts have properly decided to give directors a
wide latitude in the management of the affairs of a corporation provided always that
judgment, and that means an honest, unbiased judgment, is reasonably exercised by
them. (Business Judgement Rule)
What constitutes negligence depends upon the circumstances of the case. xxx
negligence must be determined as of the time of the transaction. xxx mistakes or errors
in the exercise of honest business judgment do not subject the officers and directors to
liability for negligence in the discharge of their appointed duties. The directors are entrusted
with the management of the affairs of the railroad. If in the course of management they arrive
at a decision for which there is a reasonable basis, and they acted in good faith, as the result
of their independent judgment, and uninfluenced by any consideration other than what they
honestly believe to be for the best interests of the railroad, it is not the function of the court
to say that it would have acted differently and to charge the directors for any loss or
expenditures incurred
while Pennsylvania, Ohio and Detroit Railroad Co. ("POD") is a wholly-owned
subsidiary of PRR.
2. PRR directly or indirectly owns the capital stock of POD. In 1943, POD had an
outstanding total of $28,483,000 "Series A" bonds which were to mature in 1977, with
an interest rate of 4.5% payable semi-annually.
3. The president of PRR, Mr. Clement, together with Mr. Pabst, VP of Finance for PRR
and president of POD. had been considering the possibility of refinancing i the Series A
bonds.
4. In the latter part of 1943, the bond market became favorable for refinancing, hence
Clement directed Pabst to contact Kuhn Loeb & Co. ("KLC") to determine whether they
could sell a price less than par and whether their idea of refinancing was sound.
5. On the following day, the directors of POD adopted a resolution authorizing the sale of
new "Series D" bonds at the best obtainable price, and sold the same to KLC subject
to the approval of the Interstate Commerce Commission ("ICC").
6. The Series D bonds, other than having a lower interest rate (3.75%), also had a sinking
fund provision which made them callable at $103 + accrued interest.
7. However, before the contract of sale of KLC was executed, Mr. Claflin, representing
Halsey, Stuart & Co. Inc. ("HSC") visited Pabst, trying to find out whether there would
indeed be a refinancing of the Series A bonds but Pabst declined to give any info, and
even said that he did not think that HSC is likely to have an opportunity to bid if ever
they was going to be a refunding.
8. HSC, together with Otis sent telegrams to Clement and the other PRR directors
requesting for an opportunity to submit a competitive bid for the Series A bonds.
Clement eventually answered and advised the latter that the "railroad has transacted
business in a very satisfactory way" and that they considered what was the "best
interest of the railroad."
9. PRR and POD applied for the approval of the Series D bonds with the ICC. Otis was
then granted leave to intervene in this application but HSC was not.
a. Otis contends that under the circumstances, competitive bidding should be
imperative and that application should be denied since savings would be
greater if a higher price would have been received for the bonds.
b. Also, the failure of PRR to consult with more than one banker (a failure to
"shop around") was a disservice to the stockholders.
10. Though a majority of the ICC Commissioners were convinced that PRR and POD did
NOT receive the best possible price for the bonds, they still held that competitive bidding
was NOT appropriate.
11. The ICC also found that the KLC transaction was an "arms-length dealing" and the
offers submitted by HSC, a rival investment company, did not have adequate
consideration.
12. Hence due to the debt reduction (according to the ICC report, the refinancing would
result in a net saving of $7,584,664.70 plus a tax saving of $1,500,000) that will be
achieved in the proposition of PRR and POD, the ICC approved their application.
13. Hence, Otis filed a complaint with the Pennsylvania District Court.
ISSUE with HOLDING
1. WON defendants failed and refused to exercise ordinary care and judgement in the
Series D bonds sale. – NO. Such is well within their business judgement.
a. Since the allegations of the complaint deal solely with the internal affairs of
the two corporations, the liability of the respective officers and directors must
be determined under the corporation laws of the states wherein the
associations were organized.
1
 b. Officers and directors shall be deemed to stand in a fiduciary relation to the
corporation, and shall discharge the duties of their respective positions in
good faith and with that diligence, care and skill which ordinarily prudent men
would exercise under similar circumstances in their personal business affairs.
c. The question is frequently asked, how does the operation of the so-called
`business judgment rule' tie in with the concept of negligence?
i. There is no conflict between the two. When the courts say that they
will not interfere in matters of business judgment, it is presupposed
that judgment reasonable diligence has in fact been exercised.
ii. A director cannot close his eyes to what is going on about him in the
conduct of the business of the corporation and have it said that he
is exercising business judgment. Courts have properly decided to
give directors a wide latitude in the management of the affairs
of a corporation provided always that judgment, and that means
an honest, unbiased judgment, is reasonably exercised by them
d. Negligence depends upon the circumstances of the case, South Penn
Collieries v. Sproul, supra; that the court will not interfere with the internal
management of corporations, and therefore will not substitute its judgment for
that of the officers and directors, Bowman v. Gum, Inc., 1937, 327 Pa. 403,
193 A. 271; and, what is a rule of reason, that negligence must be determined
as of the time of the transaction. It is also clearly established that mistakes or
errors in the exercise of honest business judgment do not subject the officers
and directors to liability for negligence in the discharge of their appointed
duties.
e. There can be no doubt that the officers and directors of both PRR and POD.
acted honestly, in good faith, and sought to exercise their judgment for the
best interests of the respective railroads. There is no contention here that
fraud was present; indeed, the allegations in the complaint contain only a
faint suggestion of bad faith, calling to the attention of the court that the
officers and directors were influenced because of their position as directors or
officers of several companies which had made purchase and sale agreements
with KLC.
f. It was the duty of the officers, in the course of business, to be on the alert for
an opportunity for refunding an outstanding bond obligation in a manner which
would result in a saving to their business, and there is no question that the
management of the defendant corporations did seize an opportune time for
the refunding operation.
i. Clement, the president, and Pabst, the vice president in charge of
finance and corporate relations, were obviously well acquainted with
the finances of the railroad.
g. The mere fact that the parties did not do competitive bidding does not, of itself,
afford a basis of liability.
i. The defendants unquestionably had the right to negotiate privately
with KLC. Although there is no charge of bad faith, or conspiracy, it
seems clear that in choosing that firm, the defendants were
following another custom in railroad history.
ii. KLC has long been "the" banking house to PRR In dealing with KLC
the defendants were dealing with a firm in which they had the
confidence of years of satisfactory banking relations and which
i
Process of retiring or redeeming an outstanding bond issue at maturity by using the proceeds from a new
debt issue. The new issue is almost always issued at a lower rate of interest than the refunded one, to ensure
significant reduction in interest expense for the issuer (Investopedia).
was well acquainted with their financial situation, structure and
requirements.
iii. Although the Commission felt no special advice was necessary, the
record of the Commission's proceedings reveals that from time to
time KLC did advise the railroad company as to their estimate of the
market, what it might absorb, the trend, and the terms of bonds and
similar matters.
iv. Failure to foresee what at best is uncertain does not constitute
negligence or mismanagement: what the market would absorb and
the terms and conditions that would meet with greatest success
were, at the time the issue involved here was planned, at most a
matter of judgment.
v. If the defendants used their honest business judgment, as I am
convinced they did, they cannot be liable for failing to accurately
foretell the welcome the market would give their efforts. I am of the
opinion no more was required of the individual defendants.
DISPOSITIVE PORTION
The various directors were aware of the proposed transaction and its course of conduct;
copies of telegrams and letters from Halsey, Stuart & Co., and Otis & Co. were sent to them;
in any event they had a right to rely on the information supplied by, and the good faith
judgment of, those in whose hands the conduct of the everyday affairs of the corporation
was placed.
For the reasons stated, the defendants' motion for summary judgment is granted.
OTHER NOTES
Please note that I did not include any procedural issues anymore since Sir seems agitated
whenever people discuss procedural issues. Suffice to say that:
This is a proper case for summary judgement since there is no substantial conflict
concerning the evidentiary facts, but only as to the inferences to be drawn therefrom, this
is a proper case for summary judgment.
Requirements for "business judgement rule" to free the directors of any liability for any loss
or expenditures incurred resulting from the decision (1) Decision made must have a
reasonable basis;(2) Directors must have acted in good faith, i.e. (a) Decision made must
be the result of the directors’ independent judgment; and (b) Decision made must be
uninfluenced by any consideration other than what the directors honestly believed to be for
the best interests of the company.
DIGESTER: