Not long ago, I represented the directors of a bank in a shareholder lawsuit. The shareholders argued that the bank had experienced poor financial performance because of unwise investments in the Northeastern U.S. real estate market, and that the board (or, more accurately, the board’s D&O insurance) should be liable for the loss, since the allegedly risky investments breached the board’s fiduciary duty. Amazingly (but not surprisingly), these very same shareholders had never complained at all during the real estate boom years, when the stock was appreciating in value and throwing off nice dividends. (Translation: “What have you done for me lately?”) We settled the case by buying back the stock, in part because my clients were convinced that the shares would rebound strongly (and, in fact, they’ve already started to do so). Had we tried the case, though, I would have leaned heavily on the business judgment rule, and I think I would have won. (Hubris!)
So: How does the business judgment rule work? The New Jersey Supreme Court has explained that the business judgment rule "is a rebuttable presumption,” and “places an initial burden on the person who challenges a corporate decision to demonstrate the decision-maker's ‘self-dealing or other disabling factor.’" If a challenger sustains that initial burden, then the "presumption of the rule is rebutted, and the burden of proof shifts to the defendant or defendants to show that the transaction was, in fact, fair to the corporation." In re PSE & G Shareholder Litigation, 173 N.J. 258, 801 A.2d 295 (N.J. 2002).
A recent New York case involving Andrea Jung, the former CEO of Avon, is a good example of how the rule operates. (The New York law is similar to the New Jersey law.) Jung had a rather dismal run as the head of the cosmetics company, with the share price dropping 53% in a little over a year. How much of this was due to Jung, and how much to the generally lousy economy, is a matter for debate. One thing we do know is that she failed to appoint a Chief Operating Officer for five years. Jung was once quoted as saying: “You have to combine good instinct with good business acumen. You can’t just be creative, and you can’t just be analytical.” When the board rejected a $10.7 million tender offer from Coty at a share price of $23.25 (later increased to $24.75, which was 40% over the trading price of Avon), some shareholders felt she had shown neither good instinct nor good business acumen, and sued. (On an unrelated point, lest anyone think that Jung was a complete foulup, I should note that, during her tenure, she helped raise more than $800 million for Avon’s charitable programs, focused on breast cancer research and preventing violence against women.)
The shareholders and their lawyers probably felt that Jung and the Board were vulnerable on several fronts. The financial press has noted that the Board members worked very closely with Jung, drawing criticism from corporate governance consultants who wanted the Board members to be more watchdogs than co-workers. In addition, the Board gave Jung considerable latitude. Most CEOs sign two- or three-year contracts. Jung’s contract was open-ended, and, in fact, the Board debated for three weeks over whether to fire her, before replacing her as CEO and retaining her as chairman.
The shareholders argued that the Board members had breached their fiduciary duty by refusing to negotiate with Coty. Note: There was no allegation that the Board or Jung had engaged in self-dealing or fraud. That’s important in this context, because arguably dumb decisions are generally protected absent some nefarious motive. Or, as the Court put it: “Plaintiffs must plead with particularity that the Board’s action was so egregious on its face that it could not have been the product of sound business judgment.”
Jung and the Board members defended themselves by explaining their rejection of Coty’s takeover proposal as follows: (1) the Board believed that Avon had good “stand-alone prospects”; (2) Coty had undervalued Avon; (3) Avon would be hiring a new Chief Executive Officer, resulting in a “greater opportunity to improve shareholder value in excess of” Coty’s offer; and (4) Coty’s offer was nonbinding, and reserved to Coty the ability to raise or lower the purchase price.
The Court characterized the substance of the shareholders’ suit as an argument “that the Board was obligated to enter into formal merger negotiations with Coty lest it be in ‘egregious’ dereliction of its duties to Avon.” The Court rejected this argument, writing: “Plaintiffs seek to substitute their judgment for that of the Board in this instance, and through this action, invite the Court to do the same…[but] the Board offered reasons for rejecting Coty’s earlier offers and sought legal and financial advice to vet Coty’s final proposal, demonstrating that the board could have been making a sound business judgment.” That was enough.
One significant “public relations” aspect to remember about this decision: the Avon Board members did not act abruptly and then attempt to explain their decision later, only after the shareholder dissatisfaction erupted. Instead, the Board had issued press releases as the process unfolded, explaining the specific reasons why it had decided not to pursue negotiations with Coty. As stated above, one of the reasons for ending the negotiation was the belief that Coty’s proposed share price undervalued Avon. So, the Board was careful to create transparency and a paper trail as it went through the process. That helps a lot.
The bottom line is that the business judgment rule creates a very limited standard of review. Unless there’s fraud, self-dealing or a deliberate effort to harm the company, directors and officers are likely insulated from personal liability. Here, in fact, you have a Board rejecting a 40% premium over the stock price, and the Court declining to second-guess the decision.
And speaking of personal liability, it’s beyond me why anyone would want to be a director or officer in the current litigious climate. Even though Jung and the board members defeated this suit, I’m sure that their lawyers’ fees were substantial. So, if you’re thinking about taking a board position, you’d better review the corporation’s D&O insurance coverage and indemnification agreements very carefully and make sure you’re fully protected.
The caption of the Avon case is Pritika v. Jung, Consolidated Index No. 651087/2012E (N.Y. Sup. Ct. N.Y. County) (Judge Bransten).
- Gene Killian