Otis & Co. v. Penn. R. R. Co., 57 F.Supp. 680 (E.D.Pa. 1944) 

Case Digest on OTIS & CO. V. PENNSYLVANIA RAILROAD CO.,

The bond issue complained of by Otis & Co., a stockholder of PRC, as having been made without bidding was found

by the court to be adequately deliberated and planned, properly negotiated and executed. The court also found that

there was no lack of good faith, no motivation of personal gain or profit; and there was no lack of diligence, skill or 

care in selling the issue at a price approved by the Commission.

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 reasonable exercised by them.

Courts will not interfere with the internal management of the corporation and therefore will not substitute its judgment

for that of the officers and directors. 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.

Requirements for BJR 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;

a. Decision made must be the result of the directors’ independent judgment; 

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.

Business Judgment Rule - Further Readings

 A legal principle that makes officers, directors, managers, and other agentsof a corporation immune from liability to the corporation for loss incurred incorporate transactions that are within their authority and power to makewhen sufficient evidence demonstrates that the transactions were madein GOOD FAITH. 

The directors and officers of a corporation are responsible for managing anddirecting the business and affairs of the corporation. They often face difficultquestions concerning whether to acquire other businesses, sell assets, expandinto other areas of business, or issue stocks and dividends. They may also facepotential hostile takeovers by other businesses. To help directors and officersmeet these challenges without fear of liability, courts have given substantialdeference to the decisions the directors and officers must make. Under the business judgment rule, the officers and directors of a corporation areimmune from liability to the corporation for losses incurred in corporate

 

transactions within their authority, so long as the transactions are made ingood faith and with reasonable skill and prudence.

The rule originated in Otis & Co. v. Pennsylvania R. Co., 61 F. Supp. 905 (D.C.Pa. 1945). In Otis, a shareholder's derivative action alleged that corporatedirectors failed to obtain the best price available in the sale of  SECURITIES  by dealing with only one investment house and by generally neglecting to "shoparound" for the best possible price, resulting in a loss of nearly half a milliondollars. The federal district court ruled that although the directors chose the wrong course of action, they acted in good faith and therefore were not liableto the shareholders. The court reasoned that "mistakes or errors in theexercise of honest business judgment do not subject the officers and directorsto liability for NEGLIGENCE in the discharge of their appointed duties."

Subsequently, the business judgment rule was applied to directors' actions when corporations were faced with a hostile takeover. In Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. Super. 1985), the Delaware SupremeCourt upheld the defensive actions taken by a board of directors during atakeover struggle with a minority shareholder. In this case Mesa PetroleumCompany made an offer that would have made it the majority shareholder inUnocal Corporation. Under the offer, shareholders who sold their Unocalstock would receive $54 a share until Mesa acquired the 37 percent it soughtand then would receive highly speculative Mesa securities instead of cash forany stock sold beyond that 37 percent. To counteract the takeover bid Unocal'sdirectors announced that if Mesa obtained 51 percent of its shares, Unocal would purchase the remaining 49 percent for an exchange of debt securities(securities reflected as debt on the books of the corporation) with an aggregatepar (or face) value of $72 a share, but the offer would not be extended to the 51percent of stock held by Mesa. Mesa filed suit, alleging that the directors had violated their fiduciary duty by excluding Mesa from the exchange. The courtconcluded that the directors' actions were protected by the business judgmentrule. The court recognized that in responding to hostile takeover bids thedirectors of a corporation can face a conflict between their own interests andthe interests of the corporation and its shareholders. The court stated that theUnocal directors had reasonable grounds to believe that a danger to thecorporation existed because of Mesa's actions and that the defensive actionsthey took were reasonable in relation to the threat they "rationally andreasonably" believed the offer posed.

Despite the seemingly broad scope of the business judgment rule, corporatedirectors have not always been able to rely upon it as a way to escape liability for their actions. In Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), the

 

Supreme Court of Delaware held that the directors of a corporation failed toexercise informed business judgment and instead acted in a grossly negligentmanner by agreeing to sell the company for only $55 a share. The court lookedto evidence indicating that the directors reached their decision to sell at thatprice after hearing only a 20-minute oral presentation concerning the sale.The court also noted that the directors had received no documentationindicating that the sale price was adequate and had not requested a study tohelp them determine whether the price was fair. Although the directors werenot accused of acting in bad faith, the court stated that the directors' fiduciary duty toward their shareholders required more than merely an absence of badfaith. The directors, according to the court, had an affirmative duty to protectthe shareholders by obtaining and reviewing information necessary to help thedirectors make sound business decisions. By failing to inform themselves they  were therefore liable to the shareholders for their bad business decision.

Even when a corporation faces a hostile takeover, the business judgment rulemay not insulate its directors from liability. In Revlon v. MacAndrews &  Forbes Holdings, 506 A.2d 173 (Del. 1985), the company attempting atakeover sought a preliminary injunction to prevent the corporation that wasthe target of the takeover from granting a lockup option, which gives a friendly third party the right to purchase part of the target company to help thwart atakeover. The Delaware Supreme Court held that the directors failed to fulfilltheir duty to preserve the company by not maximizing the sale value of thecompany for the benefit of its shareholders. According to the court, by instituting the lockup option and halting the bidding, the directors allowed"considerations other than the maximization of shareholder profits to affecttheir judgment" and thus acted to the detriment of the shareholders. Once thedirectors determined to sell the corporation, the court held, their role changedfrom that of "defenders of the corporate bastion to auctioneers charged withgetting the best price for the stockholders at the sale of the company." As aresult, the court held that the directors were not entitled to the protection of the business judgment rule.

Courts have further held that the business judgment rule will cover the actionsof directors only when the directors are disinterested and independent withrespect to the action that is at issue. A director is independent when she or heis "in a position to base [her or his] decision on the merits of the issue ratherthan being governed by extraneous considerations or influences"; conversely,a director is considered to be interested if she or he appears to be on bothsides of a transaction or expects to derive personal financial benefit from it, asopposed to a benefit to be realized by the corporation or all shareholdersgenerally ( Aronson v. Lewis, 473 A.2d 805 [Del. 1984]). Thus, if one director

 

stands to receive a substantial financial benefit from the issuance of stock nonetheless designed to counteract a takeover threat, the business judgmentrule may not apply to the board of directors' actions. Such allegations of bias,lack of independence, or disinterest must be supported by tangible evidence.

kyle

This article is totally wrong! The court in Unocal did NOT apply the business

 judgment rule (BJR) but rather created a new standard of review--henceforth the

"Unocal standard"--which is an intermediate form of scrutiny between the BJR,

which is deferential, and the entire fairness standard, which is invasive. BJR only

applies to disinterested actions by the board of directors. In Unocal, the board was

interested in a sense because the defensive measure taken was a self-tender offer

that would entrench their position as members of the board. This can be

problematic--courts want the board to act in the best interest of the shareholders,

not in their own interest just to keep their jobs. So in a unocal, contested control

type setting, the defense measures need to be motivated by the best interests of the

corporation. and even then, the directors' response needs to be reasonable and

proportionate. The court found this was so and approved the board's efforts, but this

is definitely NOT the BJR. . . under the BJR, the court essentially avoids any

substantive review of the board's actions. In most cases, where the BJR applies--

because it is so deferential, the plaintiff's claim will be dismissed before a trial on the

merits.