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Auerbach v. Bennett

New York Court of Appeals
47 N.Y.2d 619 (1979)
ELI5:

Rule of Law:

While the substantive decision of a special litigation committee of disinterested corporate directors to terminate a shareholder derivative action is protected from judicial scrutiny by the business judgment rule, courts may inquire into the disinterested independence of the committee's members and the adequacy and appropriateness of its investigative procedures.


Facts:

  • In 1975, management of General Telephone & Electronics Corporation (GTE) began an internal investigation into questionable payments made to foreign officials and political parties.
  • The board's audit committee, assisted by outside counsel and auditors, conducted a wider investigation and confirmed in a 1976 report that GTE had paid over $11 million in bribes and kickbacks.
  • The audit committee's report implicated several of the corporation's individual directors in the misconduct.
  • In response to the report, Auerbach, a GTE shareholder, initiated a derivative action against the implicated directors and the corporation's auditor, Arthur Andersen & Co.
  • The GTE board formed a special litigation committee (SLC) composed of three directors who had joined the board after the challenged transactions occurred.
  • The board delegated its full authority to the SLC to determine the corporation's position on the derivative lawsuit.
  • After its own investigation, the SLC concluded that pursuing the action was not in the best interests of the corporation and directed that the lawsuit be dismissed.

Procedural Posture:

  • Auerbach filed a shareholder derivative suit in New York Supreme Court, Special Term (trial court).
  • The defendants moved for summary judgment to dismiss the complaint based on the special litigation committee's determination.
  • The Special Term granted defendants' motion and dismissed the complaint on the merits.
  • The original plaintiff, Auerbach, chose not to appeal.
  • Wallenstein, another shareholder, filed an appeal and moved to intervene in the Appellate Division (intermediate appellate court).
  • The Appellate Division granted Wallenstein's motion to intervene and reversed the trial court's dismissal, denying the defendants' motion for summary judgment.
  • The defendants were granted leave to appeal to the Court of Appeals of New York, the state's highest court.

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Issue:

To what extent does the business judgment rule limit judicial inquiry into the decision of a special litigation committee, composed of disinterested directors, to terminate a shareholder derivative lawsuit brought against other corporate directors?


Opinions:

Majority - Jones, J.

The business judgment rule shields the substantive conclusion of a special litigation committee from judicial review, but permits limited inquiry into the committee members' disinterested independence and the appropriateness of the investigative procedures they employed. The rule recognizes that courts are ill-equipped to evaluate business judgments, a responsibility that rests with corporate directors. While the decision to prosecute a claim belongs to the corporation, when a committee is formed to make that decision regarding fellow directors, a court can legitimately scrutinize the process to ensure fairness. This inquiry is strictly limited to the committee's independence and the good-faith adequacy of its investigation. Proof that an investigation was a sham or pretext would not be shielded. Here, there was no factual dispute regarding the independence of the three new directors on the committee or the sufficiency of their procedures, which included hiring special counsel and interviewing key parties. Therefore, the committee's determination to terminate the litigation is protected by the business judgment rule and forecloses further judicial action.


Dissenting - Cooke, C.J.

Judicial inquiry should be permitted beyond the limited scope allowed by the majority, and summary judgment is inappropriate at this stage. The business judgment rule should only be conditionally applicable when directors are accused of wrongdoing. The decision to terminate the suit depends on the motives and actions of the defendants and the special litigation committee, and knowledge of these matters is exclusively within their possession. Therefore, summary judgment should not be granted before the plaintiff-intervenor has an opportunity for pretrial discovery. Denying discovery creates a 'Catch-22' situation, as the plaintiff cannot produce facts challenging the committee's good faith without the very discovery that is being denied. This effectively renders corporate directors unaccountable to the shareholders they represent.



Analysis:

This case establishes the 'Auerbach' approach for judicial review of a special litigation committee's decision to dismiss a derivative suit, which is highly deferential to the corporation. By limiting judicial review to the committee's independence and procedures, the New York rule insulates the substantive merits of the committee's decision from judicial second-guessing. This approach contrasts sharply with the 'Zapata' test adopted in Delaware, which allows courts a second, more intrusive step of applying their own independent business judgment. The Auerbach rule strengthens the power of disinterested directors to control derivative litigation and makes it significantly more difficult for shareholders in New York to proceed with suits against directors when an SLC recommends dismissal.

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