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04/21/97 ALBERT CUKER AND SABINA CUKER v. ALBERT G.

April 21, 1997

ALBERT CUKER AND SABINA CUKER, AND STANLEY KATZMAN AND SIDNEY J. SILVER, TRUSTEES FOR THE IRREVOCABLE TRUST FOR THE DESCENDANTS OF HOWARD AND PEARL KATZMAN, DERIVATIVELY, ON BEHALF OF PECO ENERGY COMPANY, RESPONDENTS
v.
ALBERT G. MIKALAUSKAS, JOSEPH F. PAQUETTE, JR., CORBIN A. MCNEILL, JR., JOHN H. AUSTIN, JR., JAMES L. EVERETT, RICHARD G. GILMORE, KENNETH G. LAWRENCE, MORTON W. RIMMERMAN, THOMAS P. HILL, JR., RAYMOND F. HOLMAN AND PECO ENERGY COMPANY, PETITIONERS



Appeal from the orders of the Philadelphia Court of Common Pleas entered on May 21, 1996 at Nos. 3470 July Term 1993 and 1278 August Term 1995, and on July 26, 1995 at No. 3470 July Term 1993. JUDGES: Hon. Pamela Pryor Cohen.

Before: Flaherty, C.j., And Zappala, Cappy, Castille, Nigro And Newman, JJ.

The opinion of the court was delivered by: Flaherty

OPINION OF THE COURT

MR. CHIEF JUSTICE FLAHERTY

DECIDED: April 21, 1997

PECO Energy Company filed a motion for summary judgment seeking termination of minority shareholder derivative actions. When the motion was denied by the court of common pleas, PECO sought extraordinary relief in this court pursuant to Pa.R.A.P. 3309. We granted the petition, limited to the issue of "whether the 'business judgment rule' permits the board of directors of a Pennsylvania corporation to terminate derivative lawsuits brought by minority shareholders."

PECO is a publicly regulated utility incorporated in Pennsylvania which sells electricity and gas to residential, commercial, and industrial customers in Philadelphia and four surrounding counties. PECO is required to conform to PUC regulations which govern the provision of service to residential customers, including opening, billing, and terminating accounts. PECO is required to report regularly to the PUC on a wide variety of statistical and performance information regarding its compliance with the regulations as interpreted by the PUC. Like other utilities, PECO is required to undergo a comprehensive management audit at the direction of the PUC approximately every ten years. The most recent audit was conducted by Ernst & Young. The report issued in 1991 recommended changes in twenty-two areas, including criticisms and recommendations regarding PECO's credit and collection function.

Two trustees, on behalf of a group of minority shareholders, made a demand on PECO, alleging wrongdoing by some PECO directors and officers. This Katzman demand, made in May, 1993, asserted that the delinquent officers had damaged PECO by mismanaging the credit and collection function, particularly as to the collection of overdue accounts. The shareholders demanded that PECO authorize litigation against the wrongdoers to recover monetary damages sustained by PECO. At its meeting of June 28, 1993, PECO's board responded by creating a special litigation committee to investigate the Katzman allegations.

Less than a month later, a second group of minority shareholders filed a complaint against PECO officers and directors. Cuker v. Mikalauskas, July Term, 1993, No. 3470 (C.P. Phila.). The Cuker complaint, filed in July, 1993, made the same allegations as those in the Katzman demand, with extensive references to the Ernst & Young audit report. The Cuker complaint was filed before the special litigation committee had begun its substantive work of investigating and evaluating the Katzman demand, so the committee's work encompassed both the Katzman and Cuker matters. Only the twelve nondefendant members of the PECO board acted to create the special committee, which consisted of three outside directors who had never been employed by PECO and who were not named in the Katzman demand or the Cuker complaint.

The work of the special committee was aided by the law firm of Dilworth, Paxson, Kalish & Kauffman, as well as PECO's regular outside auditor, Coopers & Lybrand, selected to assist in accounting matters because Coopers was knowledgeable about the utility industry and was familiar with PECO's accounting practices. The special committee conducted an extensive investigation over many months while maintaining a separate existence from PECO and its board of directors and keeping its deliberations confidential. The special committee held its final meeting on January 26, 1994, whereupon it reached its Conclusions and prepared its report.

The report of the special committee concluded that there was no evidence of bad faith, self-dealing, concealment, or other breaches of the duty of loyalty by any of the defendant officers. It also concluded that the defendant officers "exercised sound business judgment in managing the affairs of the company" and that their actions "were reasonably calculated to further the best interests of the company." The three-hundred-page report identified numerous factors underlying the Conclusions of the special committee. Significant considerations included the utility's efforts before the PUC to raise electricity rates in consequence of the expense of new nuclear generating plants. Other factors were the impact of PUC regulations limiting wintertime termination of residential service and other limitations on the use of collection techniques such as terminations of overdue customers, particularly with a large population of poverty level users among PECO's customer base. These considerations were supported by PUC documents which criticized PECO for aggressive and excessive terminations in recent years. The report of the special litigation committee also described how PECO's management had been attentive to the credit and collection function, with constant efforts to improve performance in that area. According to the report, limiting the use of terminations as a collection technique was a sound business judgment, reducing antagonism between the PUC and PECO and resulting in rate increases which produced revenue far in excess of the losses attributed to nonaggressive collection tactics. The report concluded that proceeding with a derivative suit based largely on findings of the Ernst & Young audit would not be in the best interests of PECO.

When it received the report of the special litigation committee with appendices containing the documents and interviews underlying the report, the board debated the recommendations at two meetings early in 1994. The twelve nondefendant members of the PECO board voted unanimously on March 14, 1994 to reject the Katzman demand and to terminate the Cuker action.

In the Cuker action, the court of common pleas rejected PECO's motion for summary judgment. The court stated that "the 'business judgment rule' [has been] adopted in some states but never previously employed in Pennsylvania." The court held that as a matter of Pennsylvania public policy, a corporation lacks power to terminate pending derivative litigation. On PECO's motion, the court certified four controlling questions of law to the Superior Court, pursuant to 42 Pa.C.S. § 702(b), including the question presented in this appeal. *fn1 The Superior Court denied interlocutory review, on January 31, 1996, after the Cuker plaintiffs argued that unresolved factual issues precluded review.

When the PECO board, following the recommendation of the special litigation committee, rejected the Katzman demand, the Katzman claimants filed a shareholder derivative action. Katzman v. Mikalauskas, August Term 1995, No. 1278 (C.P. Phila.). After the Superior Court denied interlocutory review of Cuker, the two cases were consolidated by the court of common pleas on February 20, 1996.

PECO then filed a petition to terminate the consolidated actions which raised issues of fact regarding the independence of the special committee and the adequacy of its investigation. The plaintiffs responded that the court of common pleas could not resolve the factual issues because of the earlier decision in the same court that a Pennsylvania corporation lacks the power to terminate pending derivative litigation. This decision presumably precluded another Judge of the same court from hearing the factual disputes. The court denied PECO's petition to terminate on May 21, 1996.

The decisions of the Superior Court on January 31, 1996 and the court of common pleas on May 21, 1996 were irreconcilably inconsistent. The Superior Court refused to consider the legal questions regarding the business judgment rule because there were unresolved factual questions pertaining to the independence of the board and the adequacy of its investigation. The court of common pleas then refused to consider the same factual disputes due to its prior holding that the business judgment rule is not the law of Pennsylvania. Because of this inconsistency, PECO sought extraordinary relief in this court under our King's Bench powers, which we granted.

The issue is whether the business judgment rule permits the board of directors of a Pennsylvania corporation to terminate derivative lawsuits brought by minority shareholders. The business judgment rule insulates an officer or director of a corporation from liability for a business decision made in good faith if he is not interested in the subject of the business judgment, is informed with respect to the subject of the business judgment to the extent he reasonably believes to be appropriate under the circumstances, and rationally believes that the business judgment is in the best interests of the corporation. 1 ALI, Principles of Corporate Governance: Analysis and Recommendations, (1994) ("ALI Principles ") § 4.01(c). The Delaware Supreme Court has written a widely quoted formulation of the rule:

It is a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Absent an abuse of discretion, that judgment will be respected by the courts. The burden is on the party challenging the decision to establish facts rebutting the presumption.

Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)(citations omitted). The Ohio Supreme Court expressed the rule as follows: "The rule is a rebuttable presumption that directors are better equipped than the courts to make business judgments and that the directors acted without self-dealing or personal interest and exercised reasonable diligence and acted with good faith." Gries Sports Enterprises, Inc. v. Cleveland Browns Football Co., 26 Ohio St. 3d 15, 20, 496 N.E.2d 959, 963-64 (1986).

Most American jurisdictions employ the business judgment rule, but there is no uniform expression of the rule. It is sometimes referred to as a doctrine. Regardless of the precise terminology, the doctrine serves several significant public policies. It encourages competent individuals to become directors by insulating them from liability for errors in judgment. See, e.g., Briggs v. Spaulding, 141 U.S. 132, 149, 35 L. Ed. 662, 11 S. Ct. 924 (1891); Weiss v. Temporary Investment Fund, Inc., 692 F.2d 928 (3d Cir. 1982), vacated on other grounds, 465 U.S. 1001 (1984). The doctrine also recognizes that business decisions frequently entail some degree of risk and consequently provides directors broad discretion in setting policies without judicial or shareholder second-guessing. See e.g., Cramer v. General Telephone & Electronics Corp., 582 F.2d 259, 274 (3d Cir. 1978), cert. denied, 439 U.S. 1129, 59 L. Ed. 2d 90, 99 S. Ct. 1048 (1979). Finally, the doctrine prevents courts from becoming enmeshed in complex corporate decision-making, a task they are ill-equipped to perform. Weiss, 692 F.2d at 941; International Insurance Co. v. Johns, 874 F.2d 1447, 1458 n.20 (11th Cir. 1989). These policies are reflected in the Conclusions of the Connecticut Supreme Court in a decision formally adopting the business judgment rule:

"The business judgment doctrine [is] a rule of law that insulates business decisions from most forms of review. Courts recognize that managers have both better information and better incentives than they. The press of market forces . . . will more effectively serve the interests of all participants than will an error-prone judicial process." The business judgment rule "expresses a sensible policy of judicial noninterference with business decisions made in circumstances free from serious conflicts of interest between management, which makes the decisions, and the corporation's shareholders. Not only do businessmen know more about business than Judges do, but competition in the product and labor markets and in the market for corporate control provides sufficient punishment for businessmen who commit more than their share of business mistakes." "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 labeled the business judgment rule." Shareholders challenging the wisdom of a business decision taken by management must overcome the business judgment rule. "For efficiency reasons, corporate decisionmakers should be permitted to act decisively and with relative freedom from a Judge's or jury's subsequent second-guessing. It is desirable to encourage directors and officers to enter new markets, develop new products, innovate, and take other business risks." 1 A.L.I., Principles of Corporate Governance (1994) § 4.01 (c) comment, p. 174.

Rosenfield v. Metals Selling Corp., 229 Conn. 771, 786-88, 643 A.2d 1253, 1262 (1994)(citations and footnotes omitted). In summary, the business judgment rule reflects a policy of judicial noninterference with business decisions of corporate managers, presuming that they pursue the best interests of their corporations, insulating such managers from second-guessing or liability for their business decisions in the absence of fraud or self-dealing or other misconduct or malfeasance.

This has been the policy of Pennsylvania for over a century, as reflected in the decisions of this court as early as 1872. Ironically, this court has never used the term "business judgment rule" in a corporate context nor has it explicitly adopted the business judgment rule. Nevertheless, a review of Pennsylvania decisions establishes that the business judgment doctrine or rule is the law of Pennsylvania.

Spering's Appeal, 71 Pa. 11 (1872), involved a shareholder's suit against an insolvent corporation's directors for mismanagement. With no evidence of fraud or self-dealing, the court posed the issue as whether the directors of a corporation may be liable for mere mismanagement. Relying on cases as early as 1742, this court adopted the business judgment rule:

71 Pa. at 24. In 1875, this court reaffirmed the rule:

From [Spering's Appeal, (supra) ,] we learn that directors are mandatories only, and as such, held to but ordinary skill and diligence, and are not responsible to their fellow corporators for the want of judgment and knowledge. They are personally liable only where they are guilty of fraudulent conduct or of acts clearly ultra vires.

Watts's Appeal, 78 Pa. 370, 392 (1875). In Swentzel v. Penn Bank, 147 Pa. 140, 152, 23 A. 405, 415 (1892), this court stated that "directors, who are gratuitous mandatories, are only liable for fraud, or for such gross negligence as amounts to fraud. . . ." In Stone v. Schiller Building & Loan Ass'n, 302 Pa. 544, 555, 153 A. 758, 761 (1931), we stated: "Officers or directors of a corporation are not personally liable for honest mistakes in judgment when doing acts within their discretion, even though such mistakes show absence of reasonable care; they are liable only when they are grossly negligent or fraudulent." In a more recent case involving a derivative lawsuit, we stated:

From an early date this Court has consistently and realistically recognized the danger of subjecting corporate directors to liability whenever any of the transactions of the company did not meet with success.

". . . The assets of a business corporation are held in lighter grasp [than those of a trust]; shares of stock are taken with notice that the assets shall be employed in making a profit, and that it is customary to take business risks."

Smith v. Brown-Borhek Co., 414 Pa. 325, 333, 200 A.2d 398, 401 (1964)(emphasis in original), quoting Hunt v. Aufderheide, 330 Pa. 362, 376-77, 199 A. 345 (1938). In another case we stated:

The directors of a business corporation are not insurers that their actions will result in pecuniary profit and they are, in the course of their duties, called upon to undertake certain calculated "business risks"; . . . for errors in judgment, exercised in good faith, the directors of a corporation should not be penalized. . . .

Selheimer v. Manganese Corp., 423 Pa. 563, 581, 224 A.2d 634, 644 (1966). These cases, cumulatively, are both application and explanation of the business judgment rule.

Respondents argue correctly that passage of the Business Corporation Law in 1933 affected caselaw espousing business judgment principles prior to 1933. Passage of the Business Corporation Law of 1933, however, merely modified the circumstances in which directors might be held liable; it did not vitiate the principles behind the business judgment rule. In other words, although a statute may alter the threshold circumstances which preclude application of the business judgment rule, a court must apply the business judgment rule if shareholders fail to prove those threshold circumstances. Stated differently, if a court makes a preliminary determination that a business decision was made under proper circumstances, however that concept is currently defined, then the business judgment rule prohibits the court from going further and examining the merits of the underlying business decision. Whatever the effect of the Business Corporation Law of 1933, as amended, 15 P.S. § 1001 et seq. (repealed), the Business Corporation Law of 1988, 15 Pa.C.S. § 1101 et seq., the Directors' Liability Act, 42 Pa.C.S. § 8361 et seq. (repealed), or the General Association Act Amendments Act, 15 Pa.C.S. § 511 et seq., application of the appropriate statutory standard is a preliminary question which must be decided before the merits of the underlying decision may be litigated. In this case, therefore, unless respondents can establish improper conduct by PECO's board of directors (fraud, self-dealing, violation of statutory duties, etc.), the board's decisions regarding PECO's credit and collection function are beyond the scope of review of any court.

Decisions regarding litigation by or on behalf of a corporation, including shareholder derivative actions, are business decisions as much as any other financial decisions. As such, they are within the province of the board of directors. 15 Pa.C.S. § 1721. Such business decisions of a board of directors are, unless taken in violation of a common law or statutory duty, within the scope of the business judgment rule. It follows that the court of common pleas erred when it held that the business judgment rule is not the law of Pennsylvania, and the Superior Court erred when it denied review rather than correcting the trial court by ruling on the first question certified under 42 Pa.C.S. § 702(b), set forth in footnote one, supra.

The errors committed in both of the lower courts demonstrate that the practical effect of this holding needs elaboration. Assuming that an independent board of directors may terminate shareholder derivative actions, what is needed is a procedural mechanism for implementation and judicial review of the board's decision. Without considering the merits of the action, a court should determine the validity of the board's decision to terminate the litigation; if that decision was made in accordance with the appropriate standards, then the court should dismiss the derivative action prior to litigation on the merits.

The business judgment rule should insulate officers and directors from judicial intervention in the absence of fraud or self-dealing, if challenged decisions were within the scope of the directors' authority, if they exercised reasonable diligence, and if they honestly and rationally believed their decisions were in the best interests of the company. It is obvious that a court must examine the circumstances surrounding the decisions in order to determine if the conditions warrant application of the business judgment rule. If they do, the court will never proceed to an examination of the merits of the challenged decisions, for that is precisely what the business judgment rule prohibits. In order to make the business ...


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