Appeal from a grant of summary judgment by the United States District Court for the District of Connecticut (Eginton, Judge), dismissing a shareholder's derivative suit as to certain of the defendants on the basis of the report of a special litigation committee and a decision to impose a protective order on the contents of the special litigation committee report. Reversed and remanded.
Oakes, Cardamone, and Winter, Circuit Judges. Cardamone, C.j., concurring, in part and dissenting in part.
This is an appeal from a grant of summary judgment for defendants by the District Court for the District of Connecticut, Eginton, Judge, dismissing a derivative action against certain directors and officers of Citytrust upon a recommendation of a special litigation committee and placing that report under seal. 519 F. Supp. 1312 (D.Conn. 1981).
In October of 1977, Dr. Athalie Doris Joy brought this shareholder's derivative suit on behalf of Connecticut Financial Services Corporation (now Citytrust Bancorp, Inc.) against its wholly-owned banking subsidiary, Citytrust,*fn1 and the officers and directors of Citytrust. Both corporations are incorporated in Connecticut. The complaint alleged diversity of citizenship, common law breach of trust and of fiduciary duty as well as violations of the National Bank Act, 12 U.S.C. § 84 (1976), which limits aggregate loans to a single person or entity to 10% of a bank's combined stockholder equity and capital. The allegations concern loans made by Citytrust to the Katz Corporation ("Katz") for construction of an office building in a redevelopment area of Norwalk, Connecticut. Plaintiff seeks a $6 million recovery plus interest and attorney's fees.
The underlying transactions need only be briefly summarized at this point. In 1967, Citytrust entered into a 20-year term lease agreement for approximately 9% of an office building which Katz was planning to build in Norwalk. Katz, then a respected developer, signed a $4 million construction mortgage for a one-and-a-half year term on January 12, 1971. Although the mortgage was written through and recorded in the name of Citytrust, Chase Manhattan Bank provided the bulk of the financing, $3.5 million, with Citytrust participating to the extent of $500,000. At this time, Katz had already borrowed, largely in unsecured form, an additional $250,000 from Citytrust to finance construction of the office building. As the building neared completion in early 1972, Katz had drawn down the full value of the $4 million mortgage. At its expiration in June, 1972, the Chase mortgage was replaced by a $4.5 million mortgage by First National City Bank, with Citytrust both issuing the mortgage and participating to the extent of $90,000. Meanwhile, Katz continued to receive unsecured loans from Citytrust. By December, 1972, that unsecured debt reached $900,000, for a total of $990,000 in Citytrust loans related to the building.
In June, 1973, with the building only half rented, the First National City mortgage was extended for a year. Katz's unsecured debt to Citytrust had by now climbed to $1,840,000. In November, in conjunction with the issuance of yet another loan to Katz, Citytrust obtained a blanket second mortgage on the building and on other Katz properties to secure what was now a total loan balance of $2,140,000. Shortly thereafter, the First National City mortgage was extended to August, 1975, and Citytrust lent Katz another $300,000. Just prior to this extension of credit, the National Bank Examiners classified the Katz loans.
In April, 1975, a refinancing plan was completed with Lincoln National Life Insurance Company providing a $6 million loan to a Katz-related partnership which had taken title to the building. The loan was secured by a first mortgage on the building and was used to consolidate Katz's debt. As a condition of the new financing, Citytrust was required to take a 30-year master lease on the still largely unrented building at a rental equaling the mortgage payments to Lincoln National, in effect guaranteeing Katz's $6 million obligation to Lincoln. In addition to undertaking the master lease, Citytrust had by now extended $2,665,000 in loans to Katz.
In May, 1975, the National Bank Examiners classified $2 million of the Katz loans as doubtful and required a charge off of $665,000. On August 18, 1976, in an apparent effort to salvage what was left of its position, Citytrust's Board of Directors authorized loans which exceeded the 10% federal statutory limit. After these loans were consummated, Katz's total indebtedness to Citytrust reached $3,545,000. On October 20, 1976, Citytrust charged off the $2 million remaining on the second mortgage.
On June 13, 1977, the Katz-related partnership relinquished title to the building to Citytrust in exchange for a release from its obligation to Lincoln National and a release of personal guarantees previously assumed by members of the Katz family. Citytrust thus directly assumed the $6 million Lincoln National mortgage. In October, 1977, Second Nutmeg Financial purchased the building for $9,600,000 which consisted of its assumption of the $6 million Lincoln National mortgage and a $3,600,000 note to Citytrust secured by a second mortgage. There is an indication in the District Court record that an affiliate of Second Nutmeg which later acquired the building has defaulted and Citytrust once again owns it, along with the concurrent obligations. There is no indication that rental income is now adequate to meet those obligations, and we appear free to assume that the other Katz properties covered by the second mortgage are not of any significant value.
In October, 1977, Joy commenced this action after making an unsuccessful demand on the Directors of Citytrust. During the pendency of this case, the Supreme Court decided Burks v. Lasker, 441 U.S. 471, 99 S. Ct. 1831, 60 L. Ed. 2d 404 (1979), holding that federal courts must apply state law in determining the authority of a committee of independent directors to discontinue derivative suits even in many cases which arise under federal law. Immediately following the Burks decision, the Board of Directors of Citytrust and Connecticut Financial Services Corporation authorized the establishment of a Special Litigation Committee to determine whether continued prosecution of this derivative action would be in the best interests of the corporation. The Committee consisted of two Board members, Marion S. Kellogg and Ernest C. Trefz.*fn2 Kellogg was elected to the Board of Directors on July 21, 1976 and commenced service on September 15, 1976. Trefz was elected to the Board on December 15, 1976 and commenced service on January 3, 1977. Neither is a defendant in this action.*fn3
By resolution dated August 15, 1979, the full Board of Directors, a majority of whom were defendants, voted to delegate to the Committee the power to review, investigate and analyze the circumstances surrounding the pending derivative action. The Committee retained independent counsel, John Murtha, Esquire, to assist its investigation.
Nine months later, the Committee issued a Report recommending that the suit be discontinued as to 23 defendants, 20 of whom were outside directors of either Citytrust or Connecticut Financial Services and three of whom were either officers or directors or both. (The 23 will hereafter be referred to as the "outside defendants"). The Committee concluded there was "no reasonable possibility" that the outside defendants would be found liable. Its Report also recommended that settlement be considered with regard to seven defendants who were the senior officers most directly involved in the Katz loans. (These seven will hereafter be referred to as the "inside defendants"). As to them, the Committee found there was a "possibility" that one or more might be found to have been negligent. Counsel for the Committee made it clear to the District Court, however, that the decision to pursue settlement was not necessarily a decision to press the litigation against the inside defendants. If settlement is not reached, the Committee will reconsider whether to recommend termination of that portion of the action also.
When plaintiff declined to withdraw the action as to the outside defendants, the corporation filed a motion to dismiss the case as to them. The District Court permitted discovery on the limited issue of the Committee's " bona fides, motivation and thoroughness." 519 F. Supp. at 1315. Portions of the Committee Report, consisting of a summary and a detailed presentation of the Committee's factual findings, supplemented by expert opinion letters and counsel's memorandum of law, were produced. These documents were put under seal pursuant to a protective order. Plaintiff was also allowed to depose a variety of persons involved in the underlying transactions and in preparation of the Report, to pose interrogatories to others, and to see various documents relating to the Report.
After discovery, Judge Eginton granted the defendants' motion for summary judgment, the protective order remaining in force. Concluding that no dispositive Connecticut case or statute exists, Judge Eginton referred to the weight of authority in cases reported elsewhere. He held that Connecticut law permits the use of a Burks committee and that the business judgment rule limits judicial scrutiny of its recommendations to the good faith, independence and thoroughness of the Committee. 519 F. Supp. at 1325. He resolved these issues favorably to the Committee and, therefore, entered summary judgment in favor of the 23 outside defendants. Plaintiff appeals from the ruling. We reverse as to both the grant of summary judgment and the sealing of the Committee report.*fn4
The grounds of liability asserted are common law claims of negligence and breach of fiduciary duty, as well as violation of the National Bank Act. We agree with Judge Eginton for the reasons stated in his opinion that the Special Litigation Committee may seek dismissal of both the state common law and federal claims if Connecticut law authorizes it to do so. 519 F. Supp. at 1318-22; Burks, supra. We also agree with him that the Connecticut statutory and case law cited by the parties is not dispositive. Our task, therefore, is to predict what the Connecticut Supreme Court would do in a case such as the one before us.
Appellees assert that, since a board of directors can delegate all its powers to a committee, Conn. Gen. Stat. Ann. § 33-318(a) (West 1982), a special litigation committee of independent directors can decide whether a derivative action should be dismissed or continued. They further argue that, when an appropriate motion is made, courts must defer to the committee's recommendation under the so-called business judgment rule, even though the delegation of power is made by directors who are defendants in the action. Judge Eginton adopted that position and limited his inquiry to the Committee's good faith, independence and thoroughness. Appellees also assert that the Committee Report in question may be kept under seal, any public use being in violation of the District Court's order. Appellant claims an absolute right to maintain a derivative action once begun and challenges the protective order on constitutional and non-constitutional grounds.
An examination of these claims requires a discussion of some underlying principles of corporate law. Our opinion first addresses the nature and function of the business judgment rule, which played a large role in persuading the District Court to dismiss this action. It turns then to the legal oddity known as the derivative action, thought by many to be an endangered species as a consequence of the evolution of special litigation committees. See Comment, Special Litigation Committees -- An Expanding and Potent Threat to Shareholder Derivative Suits, 2 Cardozo L. Rev. 169 (1980); Note, The Business Judgment Rule in Derivative Suits Against Directors, 65 Cornell L. Rev. 600 (1980); Dent, The Power of Directors to Terminate Shareholder Litigation: The Death of the Derivative Suit, 75 Northwestern L. Rev. 96 (1980). Finally, it discusses the general principles applicable to attempts by special litigation committees to terminate particular derivative actions, and their relevance to the present case.
A. The Liability of Corporate Directors and Officers and the Business Judgment Rule
While it is often stated that corporate directors and officers will be liable for negligence in carrying out their corporate duties, all seem agreed that such a statement is misleading. See generally, Lattin, Corporations, 272-75 (1971). Whereas an automobile driver who makes a mistake in judgment as to speed or distance injuring a pedestrian will likely be called upon to respond in damages, a corporate officer who makes a mistake in judgment as to economic conditions, consumer tastes or production line efficiency will rarely, if ever, be found liable for damages suffered by the corporation. See generally, Symposium, Officers' and Directors' Responsibilities and Liabilities, 27 Bus. Lawyer 1 (1971); Fever, Personal Liabilities of Corporate Officers and Directors, 28-42 (2d ed. 1974). Whatever the terminology, the fact is that liability is rarely imposed upon corporate directors or officers simply for bad judgment and this reluctance to impose liability for unsuccessful business decisions has been doctrinally labelled the business judgment rule. Although the rule has suffered under academic criticism, see, e.g., Cary, Standards of Conduct Under Common Law, Present Day Statutes and the Model Act, 27 Bus. Lawyer 61 (1972), it is not without rational basis.
First, shareholders to a very real degree voluntarily undertake the risk of bad business judgment. Investors need not buy stock, for investment markets offer an array of opportunities less vulnerable to mistakes in judgment by corporate officers. Nor need investors buy stock in particular corporations. In the exercise of what is genuinely a free choice, the quality of a firm's management is often decisive and information is available from professional advisors. Since shareholders can and do select among investments partly on the basis of management, the business judgment rule merely recognizes a certain voluntariness in undertaking the risk of bad business decisions.
Second, courts recognize that after-the-fact litigation is a most imperfect device to evaluate corporate business decisions. The circumstances surrounding a corporate decision are not easily reconstructed in a courtroom years later, since business imperatives often call for quick decisions, inevitably based on less than perfect information. The entrepreneur's function is to encounter risks and to confront uncertainty, and a reasoned decision at the time made may seem a wild hunch viewed years later against a background of perfect knowledge.
Third, because potential profit often corresponds to the potential risk, it is very much in the interest of shareholders that the law not create incentives for overly cautious corporate decisions. Some opportunities offer great profits at the risk of very substantial losses, while the alternatives offer less risk of loss but also less potential profit. Shareholders can reduce the volatility*fn5 of risk by diversifying their holdings. In the case of the diversified shareholder, the seemingly more risky alternatives may well be the best choice since great losses in some stocks will over time be offset by even greater gains in others.*fn6 Given mutual funds and similar forms of diversified investment, courts need not bend over backwards to give special protection to shareholders who refuse to reduce the volatility of risk by not diversifying. A rule which penalizes the choice of seemingly riskier alternatives thus may not be in the interest of shareholders generally.
Whatever its merit, however, the business judgment rule extends only as far as the reasons which justify its existence. Thus, it does not apply in cases, e.g., in which the corporate decision lacks a business purpose, see Singer v. Magnavox, 380 A.2d 969 (Del. Supr. 1977), is tainted by a conflict of interest, Globe Woolen v. Utica Gas & Electric Co., 224 N.Y. 483, 121 N.E. 378 (1918), is so egregious as to amount to a no-win decision, Litwin v. Allen, 25 N.Y.S.2d 667 (N.Y. Co. Sup. Ct. 1940), or results from an obvious and prolonged failure to exercise oversight or supervision, McDonnell v. American Leduc Petroleums, Ltd., 491 F.2d 380 (2d Cir. 1974); Atherton v. Anderson, 99 F.2d 883 (6th Cir.1938). Other examples may occur.
B. Shareholder Derivative Actions
Whereas ordinary lenders may and will sue directly to enforce their rights and debentureholders look to indenture trustees to enforce obligations to them, direct actions by individual shareholders for injuries to the value of their investment would be an inefficient and wasteful method of enforcing management obligations. The stake of each shareholder in the likely return is usually too small to justify bringing a lawsuit and a multiplicity of such actions would result in corporate and judicial waste. Moreover, the costs of organizing a large number of geographically diverse shareholders to bring an action are usually prohibitively high. If an alternative remedy were not available, therefore, the fiduciary obligations of corporate management, however limited, might well be unenforceable. Moreover, state or federal law may impose other duties upon directors and officers which are designed to protect shareholders through procedural or other requirements, e.g. proxy rules. Enforcement of such obligations by shareholders, even where monetary recovery by the corporation is doubtful, may be desirable. J.I. Case Co. v. Borak, 377 U.S. 426, 12 L. Ed. 2d 423, 84 S. Ct. 1555 (1964); Mills v. Electric Auto-Lite, 396 U.S. 375, 24 L. Ed. 2d 593, 90 S. Ct. 616 (1970).
The derivative action is the common law's inventive solution to the problem of actions to protect shareholder interests. In its classic form, a derivative suit involves two actions brought by an individual shareholder: (i) an action against the corporation for failing to bring a specified suit and (ii) an action on behalf of the corporation for harm to it identical to the one which the corporation failed to bring. See Ross v. Bernhard, 396 U.S. 531, 90 S. Ct. 733, 24 L. Ed. 2d 729 (1970). The technical structure of the derivative suit is thus quite unusual. Moreover, the shareholder plaintiffs are quite often little more than a formality for purposes of the caption rather than parties with a real interest in the outcome. Since any judgment runs to the corporation, shareholder plaintiffs at best realize an appreciation in the value of ...