New York Law Review

Tag: corporate governance

  • Matter of Rye Psychiatric Hosp. Ctr., Inc., 68 N.Y.2d 336 (1986): Determining Corporate Board Size When Bylaws are Silent

    Matter of Rye Psychiatric Hosp. Ctr., Inc., 68 N.Y.2d 336 (1986)

    When a corporation’s bylaws are silent on the number of directors, the default rule under New York Business Corporation Law § 702(a) is that the board shall consist of three directors.

    Summary

    This case addresses how to determine the size of a corporate board of directors when the corporate bylaws are silent on the matter. Rye Psychiatric Hospital Center’s bylaws did not specify the number of directors. A dispute arose among the shareholders, and a special meeting was held where some shareholders elected themselves as three directors. Other shareholders challenged this election, arguing that the board size had been established as six by prior practice. The New York Court of Appeals held that, because the bylaws were silent, Business Corporation Law § 702(a) applied, fixing the board size at three. The court rejected the argument that the board size could be determined by custom or acquiescence.

    Facts

    Rye Psychiatric Hospital Center (Rye Center) was incorporated in 1973 with five equal shareholders. Bylaws were adopted, but they did not specify the size of the board of directors. In 1977, a sixth shareholder joined. The corporation operated as if all six shareholders were directors, though no formal elections were held. In 1982, a dispute arose among the shareholders. Three shareholders commenced a legal proceeding challenging the sixth shareholder’s status as a board member. The remaining three shareholders then called a special meeting to elect directors. The complaining shareholders boycotted the meeting. At the meeting, the other three shareholders elected themselves as the three directors and then as officers.

    Procedural History

    The shareholders who boycotted the meeting filed a proceeding under Business Corporation Law § 619 to nullify the election. Special Term granted the petition, declaring the election invalid. The Appellate Division modified, declaring the election of three directors valid but overturning their election as officers, holding that the board size was six based on prior dealings and the complaining shareholders remained as holdover directors. The Court of Appeals reversed the Appellate Division’s determination regarding the size of the board of directors.

    Issue(s)

    Whether, when a corporation’s bylaws do not specify the number of directors, the number of directors can be determined by custom, usage, and acquiescence, or whether Business Corporation Law § 702(a) controls.

    Holding

    No, because when corporate bylaws are silent on the number of directors, Business Corporation Law § 702(a) dictates that the board shall consist of three directors.

    Court’s Reasoning

    The Court of Appeals focused on the plain language of Business Corporation Law § 702(a), which states that “[i]f not otherwise fixed under this paragraph, the number shall be three.” The court emphasized that this provision applies when the bylaws do not specify the number of directors. The court distinguished Thistlethwaite v. Thistlethwaite, which suggested that board size could be established by “custom, usage and acquiescence,” labeling this statement as non-binding dictum and incompatible with the statute’s clear mandate. The Court reasoned that allowing custom to determine board size would create uncertainty and debate, undermining the statutory policy of clarity in corporate governance. The Court stated, “Such a rule would be wholly incompatible with the clear mandate of section 702 that a board of directors shall consist of three members in the absence of a bylaw provision to the contrary.” Because Rye Center’s bylaws were silent, § 702(a) applied, fixing the board size at three. Therefore, the three shareholders who attended the special meeting validly elected themselves as directors and subsequently elected themselves as officers.

  • Auerbach v. Bennett, 47 N.Y.2d 619 (1979): The Business Judgment Rule and Special Litigation Committees

    Auerbach v. Bennett, 47 N.Y.2d 619 (1979)

    The business judgment rule protects decisions by a special litigation committee (SLC) to terminate a derivative suit, provided the committee members are disinterested, independent, and their investigative procedures are adequate and appropriate.

    Summary

    A shareholder derivative action was brought against directors of General Telephone & Electronics Corporation (GTE) for alleged illegal payments. The board formed a special litigation committee (SLC) of disinterested directors to determine if pursuing the lawsuit was in the company’s best interest. The SLC concluded it was not and moved to dismiss the suit. The court addressed the extent to which the SLC’s decision was protected by the business judgment rule. The Court of Appeals held that while the substance of the SLC’s decision is protected, courts can review the SLC’s disinterestedness, independence, and the adequacy of its investigation. Finding no issues with these factors in this case, the Court reinstated the dismissal of the derivative action.

    Facts

    GTE’s management initiated an internal investigation into potentially questionable payments to foreign officials. The audit committee, with the assistance of outside counsel and auditors, investigated worldwide operations from 1971 to 1975. Their report revealed possible bribes and kickbacks totaling over $11 million, involving some directors. A shareholder, Auerbach, filed a derivative action against GTE’s directors and its auditor, Arthur Andersen & Co. The board then created a special litigation committee (SLC) comprised of three disinterested directors who joined the board after the transactions in question.

    Procedural History

    The SLC determined that pursuing the derivative action was not in the corporation’s best interest and directed dismissal. The corporation and the defendant directors moved to dismiss the complaint. The Supreme Court, Special Term, granted the motions and dismissed the complaint. When Auerbach didn’t appeal, another shareholder, Wallenstein, appealed. The Appellate Division reversed the Special Term’s order and denied the defendants’ motions for summary judgment. The Court of Appeals granted defendants’ motion for leave to appeal.

    Issue(s)

    1. Whether the business judgment rule bars judicial inquiry into the decision of a special litigation committee of disinterested directors to terminate a shareholder derivative action.

    2. Whether the court can inquire into the disinterestedness and independence of the committee members and the appropriateness of their investigative procedures.

    Holding

    1. Yes, the business judgment rule generally protects the substantive decision of a special litigation committee to terminate a derivative suit because courts are ill-equipped to evaluate business judgments.

    2. Yes, because the court can inquire into the disinterested independence of the committee members and the appropriateness and sufficiency of the investigative procedures chosen and pursued by the committee, but absent evidence of bad faith or fraud, the court should respect the SLC’s determinations.

    Court’s Reasoning

    The Court reasoned that derivative claims belong to the corporation, and the decision to pursue them lies within the board’s judgment. The business judgment rule protects directors’ decisions made in good faith and with honest judgment. The Court acknowledged that courts are not equipped to evaluate business decisions. The Court emphasized that the business judgment rule shields the decisions of the SLC only if its members are disinterested and independent. The court can examine the committee’s investigative procedures to ensure adequacy and appropriateness, but it cannot delve into the committee’s substantive evaluation or the weight given to various factors. The court stated, “Questions of policy of management, expediency of contracts or action, adequacy of consideration, lawful appropriation of corporate funds to advance corporate interests, are left solely to their honest and unselfish decision…and the exercise of them for the common and general interests of the corporation may not be questioned, although the results show that what they did was unwise or inexpedient.” The Court found no evidence to challenge the disinterestedness of the SLC members or the adequacy of their investigation, which included engaging special counsel, reviewing prior reports, interviewing directors and employees, and obtaining legal advice. The court also addressed the intervener’s argument for further discovery, finding it speculative and not a basis to postpone summary judgment. The disclosure proposed by Wallenstein would only go to particulars as to the results of the committee’s investigation and work. Therefore, the Court modified the Appellate Division’s order and reinstated the Special Term’s dismissal of the complaint.

  • Triggs v. Triggs, 46 N.Y.2d 305 (1978): Enforceability of Contractual Provisions Despite Illegality of Other Terms

    Triggs v. Triggs, 46 N.Y.2d 305 (1978)

    An agreement containing illegal provisions regarding corporate officer elections and compensation can still be enforced regarding a separate, legal stock purchase option, if the illegal provisions were never enforced and did not restrict corporate management.

    Summary

    This case addresses whether an agreement including an otherwise valid stock purchase option can be enforced when other provisions within the same agreement are arguably illegal because they impinge upon the board of directors’ authority. The New York Court of Appeals held that because the illegal provisions were never enforced and did not actually restrict the board’s management of the company, the stock purchase option remained enforceable. The Court emphasized that the critical factor was whether the illegal provisions stultified the Board. The court affirmed the order of specific performance of the stock purchase option.

    Facts

    Ransford Triggs (son) and his father, Triggs, Sr., entered into an agreement on March 19, 1963, which contained a stock purchase option allowing the son to purchase his father’s shares in Triggs Color Printing Corporation upon the father’s death. The agreement also contained provisions requiring the election of the son and father as officers and fixing their compensation. The father later died, and his executor refused to honor the stock purchase option. The son sued for specific performance.

    Procedural History

    The trial court granted specific performance of the stock purchase option to the son. The Appellate Division agreed with the trial court’s decision. The executor appealed to the New York Court of Appeals, arguing the entire agreement was illegal and unenforceable.

    Issue(s)

    Whether an agreement that contains both a valid stock purchase option and provisions that potentially restrict the board of directors’ management authority is unenforceable in its entirety, even if the restrictive provisions were never enforced.

    Holding

    No, because the potentially illegal provisions of the agreement were never enforced and did not, in fact, restrict the freedom of the board of directors to manage corporate affairs; therefore, the stock purchase option is enforceable.

    Court’s Reasoning

    The Court of Appeals reasoned that while provisions requiring the election of specific officers and fixing their compensation could be considered an impermissible restriction on the board of directors’ authority under cases like Manson v. Curtis, the evidence showed these provisions were ignored. The Court highlighted that the management of corporate affairs was not restricted due to the agreement. The Court emphasized that the critical factual determination was that the agreement “did not in any way sufficiently stultify the Board of Directors in the operations of this business”. The Court differentiated between the stock purchase option, which standing alone was not illegal, and the provisions concerning officer elections and compensation, which only became illegal if they restricted the board’s freedom. Since the latter provisions were not enforced, they did not invalidate the stock purchase option. The court noted, “There would have been illegality only if the election of those officers or the determination of their compensation had been in consequence of the prior agreement and thus in constraint of the freedom of the board of directors to exercise their responsibilities of management.” Because the courts below enforced only the stock option provisions, the order of the Appellate Division was affirmed. The Court also affirmed that the stock purchase option survived the execution and cancellation of a separate stock repurchase agreement with the corporation because of the intent of the parties and the son’s belief that he would retain control of the business.

  • Hyman v. Jewish Chronic Disease Hospital, 15 N.Y.2d 317 (1965): Director’s Right to Inspect Hospital Records

    15 N.Y.2d 317 (1965)

    A director of a corporation, including a hospital, has the right to inspect the corporation’s records to investigate potential wrongdoing, even concerning patient data, subject to reasonable safeguards to protect patient confidentiality.

    Summary

    William Hyman, a director of Jewish Chronic Disease Hospital, sought to inspect hospital records related to alleged improper experimentation on patients. The hospital resisted, arguing patient confidentiality and lack of director liability. The Court of Appeals held that Hyman, as a director, had a right to inspect the records to fulfill his duties, even if patient data was involved. The court emphasized the director’s responsibility to oversee the corporation’s activities and the ability of the court to protect patient privacy through appropriate orders. This case establishes a director’s broad inspection rights to ensure corporate accountability.

    Facts

    William Hyman, a director of the Jewish Chronic Disease Hospital, alleged that the hospital was conducting illegal and improper experiments on patients without their informed consent.
    Hyman sought to inspect the hospital’s records to investigate these allegations.
    The hospital denied Hyman access to the records, citing patient confidentiality and arguing that Hyman, as a director, would not be personally liable for the hospital’s wrongdoing.

    Procedural History

    Hyman petitioned the court for an order compelling the hospital to allow him to inspect the records.
    Special Term initially ruled in favor of Hyman, granting him the right to inspection.
    The Appellate Division reversed the Special Term’s decision.
    Hyman appealed to the Court of Appeals.

    Issue(s)

    Whether a director of a hospital corporation has the right to inspect the hospital’s records, including patient data, to investigate alleged illegal and improper experimentation on patients.

    Holding

    Yes, because a director has a right and obligation to keep informed about the corporation’s policies and activities to fulfill their duties and responsibilities, and the court can implement safeguards to protect patient confidentiality.

    Court’s Reasoning

    The Court of Appeals reasoned that directors have a fundamental right and obligation to stay informed about a corporation’s activities to properly discharge their duties. This right extends to inspecting corporate records, even those containing sensitive information like patient data, especially when investigating potential wrongdoing.
    The court rejected the hospital’s argument that patient confidentiality should bar Hyman’s inspection, noting that any confidentiality concerns could be addressed by the court through appropriate orders, such as concealing patient names. The court stated, “Any such confidentiality could be amply protected by inserting in the court’s order a direction that the names of the particular patients be kept confidential.”
    The court also dismissed the argument that Hyman’s lack of personal liability negated the need for inspection, emphasizing that the potential liability of the corporation itself warranted the director’s inquiry. The court noted, “However, the possibility of liability of the corporation of which he is a director entitles him to learn the truth about the situation on which such alleged liability may be predicated.” The court further emphasized that Hyman was acting in his capacity as a director, fulfilling his duty to oversee the corporation’s affairs, not as a representative of the patients. The fact that the hospital had implemented new rules requiring informed consent was not a barrier to Hyman’s investigation of past actions. The dissenting opinion argued that inspection was unnecessary given ongoing investigations by the State Department of Education and the District Attorney, the petitioner’s existing knowledge of the facts, and the hospital’s new informed consent policy.

  • Matter of Estate of Wilson, 21 N.Y.2d 782 (1968): Testamentary Trust Validity and Corporate Control

    Matter of Estate of Wilson, 21 N.Y.2d 782 (1968)

    A testamentary trust that unduly restricts the power of a corporation’s board of directors by dictating operational decisions is invalid, and if such restrictions are integral to the testator’s intent, the entire trust may fail.

    Summary

    This case concerns the validity of a testamentary trust established by the testator, Wilson, who bequeathed his controlling shares in W. S. Wilson Corporation to a trust. The will directed the trustees, all employees of the corporation, to vote the stock to elect themselves as directors and to ensure the testator’s wife (and later, daughter) served as chairman of the board with a minimum compensation. The trustees sought a construction of the will, arguing the trust’s provisions violated corporate law. The court found certain provisions invalid as they infringed upon the directors’ managerial discretion. A dissenting opinion argued that these invalid provisions were so fundamental to the testator’s intent that the entire trust should fail, leading to intestacy.

    Facts

    The testator, W.S. Wilson, owned 68% of the shares of W. S. Wilson Corporation. He bequeathed these shares to a testamentary trust (Trust No. 1). The trustees were six employees of the corporation, to serve without compensation from the trust and only as long as they remained employed by the company. The will mandated the trustees to vote the stock to elect themselves as directors. The will also stipulated that the testator’s widow (and upon her death, his daughter) should be appointed chairman of the board at a minimum salary of $12,000 per year, plus a bonus. The will further restricted the board’s power by limiting their ability to increase commission rates for the corporation’s salesmen unless certain business targets were met.

    Procedural History

    The trustees, facing potential conflicts of interest, petitioned for a construction of the will, arguing the trust was invalid. The lower courts ruled on the validity of specific provisions. The case reached the New York Court of Appeals, where the decision was modified, affirming in part and reversing in part the lower court’s ruling.

    Issue(s)

    1. Whether the provisions of the testamentary trust, which direct the trustees to vote the testator’s stock to elect themselves as directors and to appoint his wife (or daughter) as chairman of the board with a specified compensation, are invalid as an impermissible restriction on the powers of the corporation’s board of directors?

    2. Whether, if some provisions of the trust are invalid, those provisions are so integral to the testator’s intent that the entire trust should fail?

    Holding

    1. Yes, because directions in a will cannot usurp the power granted to a board of directors to manage the business of a corporation according to their best judgment.

    2. The dissenting judges said Yes, because the testator conditioned the trust’s existence on the now-invalidated provisions, indicating his intent that the entire trust should fail if those conditions could not be met.

    Court’s Reasoning

    The court majority agreed that the direction to appoint the testator’s widow or daughter as chairman of the board with a specified salary was invalid because it interfered with the directors’ fiduciary duty to manage the corporation. Citing General Corporation Law § 27, the court emphasized that the business of a corporation must be managed by its board of directors, free from undue restrictions imposed by a testator. The dissenting judge said that the invalid provisions were fundamental to the testator’s purpose. He quoted the testator’s will: “As a condition of this trust I direct that my W. S. Wilson Corporation stock shall be so voted as to provide for the services of both my Wife and my Daughter…”. According to the dissent, the testator made it clear that he had no intention of creating the trust unless these directions were followed. The dissenting opinion cites Scott, Trusts (2d ed., 1956, Vol. 1, pp. 581-582): that the gift is absolute unless it appears that the testator would probably have desired that if the condition should be illegal the gift should fail altogether. Therefore, the dissent argued, the entire trust should fail, and the assets should pass to the widow and daughter through intestacy. This case highlights the tension between testamentary freedom and the legal requirement that corporate directors exercise independent judgment in managing a corporation. The dissent’s reasoning emphasizes the importance of discerning the testator’s intent and refusing to enforce a trust when its essential elements are invalidated, changing the testamentary scheme. “principal purpose and intent to enable my trustees to retain my stock in W. S. Wilson Corporation * * * upon the condition that a minimum income shall be thus payable to my Wife and my Daughter for life, and thereafter as herein provided.”