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Litwin v. Allen

    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 corporation’s 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.â€Â  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.â€Â  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 director’s independent business judgment for which they should not be held.

    Discussion.

    In general, hesitation exists to hold directors liable for questionable conduct.  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 that qualified persons will be discouraged from serving as directors.  In addition, directors may be overly cautious and pass up a desirable business risk out of fear of being held for any loss that might result.  The fear of directors’ personal liability is often cited to justify broad indemnification and insurance provisions and for the adoption of state statutes defining the scope of directors’ duties.



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