A standard technique used by corporate directors to protect themselves from legal attack is running into increasing skepticism in the courts. Last month, the Supreme Court of North Carolina voted to reject the device entirely.
At issue are what are called "derivative actions" -- lawsuits brought in the name of the corporation by dissident stockholders, not by its officials.
Typically, the suits are against the managers who control the operation, and claim that those managers ran things to line their own pockets rather than for the good of the corporation.
Usually, corporations want to get such suits thrown out of courts as soon as possible.
Judges employ a "business judgment rule," which says that those who run a business are the best ones to decide on strategy, and that it is not the job of the courts to second-guess any reasonable executive decision.
If a dispute centers on such a business judgment, the judge will reject it summarily, without letting the controversy get to a trial over the merits of the corporate strategy being followed.
But when the allegation is that the executives were choosing a strategy in their own self-interest rather than that of the business, it may be inappropriate to dismiss the action without a trial.
In 1979, New York State adopted a compromise position. If a "special litigation committee" appointed by a company's board of directors decided that the allegations in a derivative suit filed by dissident stockholders had no merit -- that the only issues were those on which competent business executives might differ -- then the court would order the case dismissed.
The special committees had to be made up of directors with no interest in the transactions being questioned, and that might mean finding some outside directors to add to the board to make up an impartial committee.
But if the committee members were truly independent, the court would defer to their advice. That rule has since been adopted under Virginia, Delaware, Connecticut, Massachusetts, Michigan, Alabama and California law. The U.S. Court of Appeals in San Francisco called it a "clear trend in corporate law."
Judges in some of these states have been uneasy, however, about the fact that often the independent directors have been picked by the very officials accused of wrongdoing. Some judges have decided that they have a duty to take a deep look at the finding of a special litigation committee that recommends dropping a derivative suit to ensure that the underlying reasoning is sound.
North Carolina, however, has gone further. In Alford v. Shaw, the North Carolina Supreme Court justices flatly refused to let directors accused of wrongdoing turn over to a committee they had selected the decision on how to respond to the suit.
The ruling follows a similar holding by the Iowa Supreme Court and may represent a turning point in the use of such special board committees.
The justices note that law journal articles have been critical of the 1979 New York decision that kicked off the trend, and such journal articles carry significant weight in the continuing development of legal rules.
In other cases, courts ruled that:
Outside lawyers hired by a company to talk workers into rejecting a bid for unionization must file with the Labor Department the details of the financial arrangement. Under the Labor-Management Reporting and Disclosure Act, any entity that gives advice on labor relations has to tell the department annually how much it has been paid for the services, and how it used the money. The requirement has long been upheld against claims that it unconstitutionally imposes on free speech.
But in the most recent attack on the statute, a new claim was argued: that when the adviser is a law firm, the filing demand interferes with the attorney-client privilege -- a right to keep secret communications between the two parties.
But the judges upheld the provision, pointing out that it does not get at the substance of any discussions between the company and its lawyers, and that subjects such as who a client is and how much the lawyer is being paid are not covered by the privilege.
(Humphreys, Hutcheson v. Donovan, Feb. 20)
Executives covered by group life insurance policies obtained by their employers are not the individuals to whom the policies were issued, even if the executives own the policies. That was more than a technical distinction in a recent controversy, in which the insurance company tried to get out of paying on the policy because it looked as though the executive had committed suicide. Missouri, where the company was located, forbids insurance companies from including exclusions for suicide in policies issued to its citizens.
But the official who was covered lived across the river in Kansas. The insurance company still has to pay up, the U.S. Court of Appeals in St. Louis ruled. The proper test, the court majority explained, is who was doing the actual purchasing; because the Missouri company handled the transaction, the protections of Missouri law apply.
(Perkins v. Phila. Life, Feb. 22)
A court reporter's business is not exempt from local taxation. The federal government claimed that Pittsburgh was acting unconstitutionally in trying to impose a franchise tax on the income a court reporter in the local federal court gets from selling trial transcripts.
Such sales routinely supplement a court reporter's salary, and although the trial court agreed that the tax violates the rule that the national government cannot be made subservient to the states, the U.S. Court of Appeals in Philadelphia reversed the decision. Because Congress allows states to impose income taxes on federal employes, it has implicitly approved collection of franchise taxes, too, the judges decided.
(U.S. v. Pittsburgh, March 5)
A disgruntled losing bidder in a federal contract may be able to sue the winner in state court. The U.S. Court of Appeals in Atlanta approved such legal action by the second low bidder in a contract expressly set aside for small business. The claim: the winning bidder was not really a small business. The loser sued, alleging fraud, unjust enrichment and interference with a business relationship -- torts traditionally tried in state courts.
The federal law setting up these set-aside programs leaves room for such state court suits, the majority reasoned, because they will help enforce the underlying purpose of channeling more government business to truly small businesses. The state court approach lets the losing bidder skip over the federal agency bid-protest procedures that would have to be exhausted before the controversy could get to federal court.
(Tectonics v. Castle Construction, Feb. 21)