Litwin v. Allen
Supreme Court of New York 25 N.Y.S.2d 667 (1940)
Brief Fact Summary.
Stockholders (Plaintiff) brought a derivative action against Trust Company
(Defendant), its subsidiary, Guaranty Company (Defendant), and J.P. Morgan
& Co. (Defendant) for a loss resulting from a bond transaction.
Synopsis of Rule of Law.
A director is not liable for loss or damage other than what was proximately
caused by his own acts or omissions in breach of his duty. s resulting from a
bond transaction.
Facts.
On October 16, 1930, Trust Company (Defendant) and its subsidiary,
Guaranty Company (Defendant), agreed to participate in the purchase of
$3,000,000 in Missouri Pacific Convertible Debentures, through the firm of
J.P. Morgan & Co. (Defendant), at par, with an option to the seller, Alleghany
Corporation, to repurchase them at the same price at any time within six
months. The purpose of the purchase was to enable Alleghany to raise
money to pay for particular properties without going over its borrowing limit.
The only purpose served by the option therefore, was to make the
transaction conform as closely as possible to a loan without the usual
incidents of a loan transaction. The decision to purchase was made after the
October 1929 stock market crash when the market was in a slight upswing
that started in April 1930. After October 1930, there was another sharp and
unexpected drop in the market. Guaranty (Defendant) and Trust (Defendant)
could not sell any of the bonds until October 8, 1931, and the last were not
sold until December 28, 1937, which resulted in a loss of $2,250,000.
Stockholders (Plaintiff) brought a derivative action to hold the directors liable
for the loss.
Issue.
Is a director liable for loss or damage other than what was proximately caused
by his own acts or omissions in breach of his duty?
Held.
(Shientag, J.) No. Directors stand in a fiduciary relationship to their company.
They are bound by rules of conscientious fairness, morality, and honesty,
which are imposed by the law as guidelines for those who are under fiduciary
obligations. A director owes a loyalty to his corporation that is undivided and
an allegiance uninfluenced by no consideration other than the welfare of the
corporation. He must conduct the corporations business with the same
degree of care and fidelity, as an ordinary prudent man would exercise when
managing his own affairs of similar size and importance. A director of a bank
is held to stricter accountability. He must use that degree of care ordinarily
exercised by prudent bankers, and, if he does so, he will be absolved from
liability even though his opinion may turn out to be mistaken and his
judgment faulty. The facts in existence at the time of their occurrence must
be considered when determining liability. In this case, the first question was
whether the bond purchase was ultra vires. It would seem that if it is against
public policy for a bank, anxious to dispose of some of its securities, to agree
to buy them back at the same price, it is even more so where a bank
purchases securities and gives the seller the option to buy them back at the
same price, thereby incurring the entire risk of loss with no possibility of gain
other than the interest derived from the securities during the period the bank
holds them. Therefore, regarding the price of securities, the bank inevitably
assumed any risk of heavy loss, and any sharp rise was assured to benefit the
seller. Trust (Defendant) could not avoid liability by having an agreement
with its subsidiary, Guaranty (Defendant), for Guaranty (Defendant) to take
any loss, should it occur. In this case, the entire arrangement was so
improvident, so risky, so unusual and unnecessary as to be contrary to
fundamental conceptions of prudent banking practice. Therefore, the
directors must be held personally liable. The second question, in this case,
was whether they were liable for the entire 81 percent loss or whether their
liability was limited to the percentage lost during the six-month option period.
A director is not liable for loss or damage other than what was proximately
caused by his own acts or omissions in breach of his duty. Only the option
was tainted with improvidence. When the option expired, any loss that
followed was the result of the directors independent business judgment for
which they should not be held.
Discussion.
In general, hesitation exists to hold directors liable for questionable conduct. HELD V2
The main fear is that the directors financial liabilities may be devastating.
Though the chance of such liabilities being imposed may be small, it is feared DISCUSSION
that qualified persons will be discouraged from serving as directors. In
addition, directors may be overly cautious and pass up a desirable business The court held trust company had no interest in third-party corporation; thus,
risk out of fear of being held for any loss that might result. The fear of defendant officers had not breached their duty.
directors personal liability is often cited to justify broad indemnification and
insurance provisions and for the adoption of state statutes defining the scope Plaintiffs also charged defendant officers' bond acquisition on trust
of directors duties. company's behalf constituted an improper loan to third-party corporation.
The court held that the bonds were purchased negligently but that the
FACTS V2 applicable statute of limitations prevented recovery against three defendant
officers.
Alleghany Corporation held $23,500,000 in unsecured bonds in Missouri
Pacific. Alleghany purchased several properties, and in 1930 still owed over Plaintiffs also claimed defendant officers negligently extended a loan to a
$10,000,000 on the purchase price. Alleghany was unable to borrow the third-party company and then improperly auctioned the loan's collateral due
money, and instead, on November 18, 1930, sold $10,000,000 in its Missouri to improper influence from defendant banking firm.
Pacific bonds to banking firm J.P. Morgan & Co. for cash at par value, with an
option for Alleghany to buy back the bonds within six months for the price at The court followed the rule that allowed deference to business decisions, and
which they were sold to J.P. Morgan. Guaranty Trust Company (Trust held defendant directors properly extended the loan using information they
Company) made a written commitment to J.P. Morgan to participate in the possessed and that their auction of the loan's collateral was equitable.
purchase, and Guaranty Company of New York (Guaranty Company), a
subsidiary of Trust Company, agreed to take over the bonds upon expiration CONCLUSION
of the six month repurchase option, if Alleghany failed to exercise the option. The court entered partial judgment in favor of plaintiffs as to their claim
The bonds had already been steadily declining in value in 1930. On November involving the improper purchase of bonds, due to defendant officers'
5, 1930, when the board of directors of Trust Company approved the negligence in approving the bond purchase. The court entered judgment in
transaction, the bonds were selling at 102 7/8. On November 18, 1930, when favor of defendants as to plaintiffs' other claims.
the board of directors of Guaranty Company approved their commitment, the
bonds were valued at 98 5/8. On April 16, 1931, when the six month
repurchase option expired, the bonds were selling at 86 high and 81 low.
Guaranty Company took them over from Trust Company at par and carried
them on its books as an investment. Shareholders owning 36 out of 900,000
shares of stock in Trust Company (plaintiffs) have brought a derivative suit
against the directors of Trust Company and Guaranty Company, and
members of J.P. Morgan (defendants), seeking to impose liability for losses
resulting from the transaction.