In October of 1977, Dr. Athalie Doris Joy brought this shareholder's derivative suit on behalf of Connecticut Financial Services Corporation (now Citytrust Bancorp, Inc.) against its wholly-owned banking subsidiary, Citytrust, and the officers and directors of Citytrust. The allegations concern loans made by Citytrust to the Katz Corporation (“Katz”) for construction of an office building in a redevelopment area of Norwalk, Connecticut.

A. The Liability of Corporate Directors and Officers and the Business Judgment Rule

While it is often stated that corporate directors and officers will be liable for negligence in carrying out their corporate duties, all seem agreed that such a statement is misleading. See generally, Lattin, Corporations, 272-75 (1971). Whereas an automobile driver who makes a mistake in judgment as to speed or distance injuring a pedestrian will likely be called upon to respond in damages, a corporate officer who makes a mistake in judgment as to economic conditions, consumer tastes or production line efficiency will rarely, if ever, be found liable for damages suffered by the corporation. See generally, Symposium, Officers' and Directors' Responsibilities and Liabilities, 27 Bus.Lawyer 1 (1971); Fever, Personal Liabilities of Corporate Officers and Directors, 28-42 (2d ed. 1974). Whatever the terminology, 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 labelled the business judgment rule. Although the rule has suffered under academic criticism, see, e.g., Cary, Standards of Conduct Under Common Law, Present Day Statutes and the Model Act, 27 Bus.Lawyer 61 (1972), it is not without rational basis.

First, shareholders to a very real degree voluntarily undertake the risk of bad business judgment.

Second, courts recognize that after-the-fact litigation is a most imperfect device to evaluate corporate business decisions. The circumstances surrounding a corporate decision are not easily reconstructed in a courtroom years later, since business imperatives often call for quick decisions, inevitably based on less than perfect information. The entrepreneur's function is to encounter risks and to confront uncertainty, and a reasoned decision at the time made may seem a wild hunch viewed years later against a background of perfect knowledge.

Third, because potential profit often corresponds to the potential risk, it is very much in the interest of shareholders that the law not create incentives for overly cautious corporate decisions. Some opportunities offer great profits at the risk of very substantial losses, while the alternatives offer less risk of loss but also less potential profit. Shareholders can reduce the volatility FN5 of risk by diversifying their holdings. In the case of the diversified shareholder, the seemingly more risky alternatives may well be the best choice since great losses in some stocks will over time be offset by even greater gains in others.FN6 Given mutual funds and similar forms of diversified investment, courts need not bend over backwards to give special protection to shareholders who refuse to reduce the volatility of risk by not diversifying. A rule which penalizes the choice of seemingly riskier alternatives thus may not be in the interest of shareholders generally. #p#分页标题#e#

Whatever its merit, however, the business judgment rule extends only as far as the reasons which justify its existence. Thus, it does not apply in cases, e.g., in which the corporate decision lacks a business purpose, see Singer v. Magnavox, 380 A.2d 969 (Del.Supr.1977), is tainted by a conflict of interest, Globe Woolen v. Utica Gas & Electric Co., 224 N.Y. 483, 121 N.E. 378 (1918), is so egregious as to amount to a no-win decision, Litwin v. Allen, 25 N.Y.S.2d 667 (N.Y.Co.Sup.Ct.1940), or results from an obvious and prolonged failure to exercise oversight or supervision, McDonnell v. American Leduc Petroleums, Ltd., 491 F.2d 380 (2d Cir.1974); Atherton v. Anderson, 99 F.2d 883 (6th Cir.1938). Other examples may occur.

B. Shareholder Derivative Actions

Whereas ordinary lenders may and will sue directly to enforce their rights and debentureholders look to indenture trustees to enforce obligations to them, direct actions by individual shareholders for injuries to the value of their investment would be an inefficient and wasteful method of enforcing management obligations. The stake of each shareholder in the likely return is usually too small to justify bringing a lawsuit and a multiplicity of such actions would *887 result in corporate and judicial waste. Moreover, the costs of organizing a large number of geographically diverse shareholders to bring an action are usually prohibitively high. If an alternative remedy were not available, therefore, the fiduciary obligations of corporate management, however limited, might well be unenforceable.

The derivative action is the common law's inventive solution to the problem of actions to protect shareholder interests. In its classic form, a derivative suit involves two actions brought by an individual shareholder: (i) an action against the corporation for failing to bring a specified suit and (ii) an action on behalf of the corporation for harm to it identical to the one which the corporation failed to bring. See Ross v. Bernhard, 396 U.S. 531, 90 S.Ct. 733, 24 L.Ed.2d 729 (1970). The technical structure of the derivative suit is thus quite unusual. Moreover, the shareholder plaintiffs are quite often little more than a formality for purposes of the caption rather than parties with a real interest in the outcome. Since any judgment runs to the corporation, shareholder plaintiffs at best realize an appreciation in the value of their shares. The real incentive to bring derivative actions is usually not the hope of return to the corporation but the hope of handsome fees to be recovered by plaintiffs' counsel.

However, there is a danger in authorizing lawyers to bring actions on behalf of unconsulted groups. Derivative suits may be brought for their nuisance value, the threat of protracted discovery and litigation forcing settlement and payment of fees even where the underlying suit has modest merit. Such suits may be harmful to shareholders because the costs offset the recovery. Thus, a continuing debate surrounding derivative actions has been over restricting their use to situations where the corporation has a reasonable chance for benefit. #p#分页标题#e#

C. Termination of Derivative Suits by Special Litigation Committees

In the normal course of events a decision whether to bring a lawsuit is a corporate economic decision subject to the business judgment rule. United Copper Securities Co. v. Amalgamated Copper Co., 244 U.S. 261, 37 S.Ct. 509, 61 L.Ed. 1119 (1917). Thus, shareholders upset at a corporate failure to bring actions for, say, non-payment of a debt for goods sold and delivered, may not initiate a derivative suit without first making a demand upon the directors to bring the action. Where the directors refuse, and the derivative action challenges that refusal, courts apply the business judgment rule to the action of the directors. In a demand-required case, therefore, the directors' decision will be conclusive unless bad faith is proven.

Different rules apply, however, in the cases which primarily concern us here. When there is a conflict of interest in the directors' decision not to sue because the directors themselves have profited from the transaction underlying the litigation or are named defendants, no demand need be *888 made and shareholders can proceed directly with a derivative suit. Note, Demand on Directors and Shareholders as a Prerequisite to a Derivative Suit, 73 Harv.L.Rev. 746, 753-56 (1960). It is in demand-not-required cases that the special litigation committee plays its role.

Appellees argue that, because special litigation committees are composed of “independent” directors-usually newly-elected directors who are not defendants-courts should treat their recommendations as the equivalent of a board refusal to bring an action in demand-required cases. If that proposition were accepted, the business judgment rule would apply in full force to the recommendation, and judicial scrutiny would be limited to the good faith, independence and thoroughness of the committee, as it is in the case of everyday business decisions. Appellant argues, on the other hand, that such committees are transparent devices enabling implicated directors to avoid liability and that derivative actions in demand-not-required cases are immune from termination whatever the recommendation of special litigation committees. We disagree with both parties.

We believe Connecticut would not adopt appellees' contention that the business judgment rule should play a major role where a special litigation committee recommends termination of an action in a demand-not-required case, such as the one before us.FN7 As a practical matter, new board members are selected by incumbents. The reality is, therefore, that special litigation committees created to evaluate the merits of certain litigation are appointed by the defendants to that litigation. It is not cynical to expect that such committees will tend to view derivative actions against the other directors with skepticism. Indeed, if the involved directors expected any result other than a recommendation of termination at least as to them, they would probably never establish the committee.FN8 The conflict of interest which renders the business judgment rule inapplicable in the case of directors who are defendants is hardly eliminated by the creation of a special litigation committee. #p#分页标题#e#

It is here that we part company with Judge Cardamone. While he recognizes that the business judgment rule has never applied to corporate decisions tainted by a conflict of interest, he argues that the conflict in the defendants' creation of a committee to determine whether this action should be terminated is wholly cured by a judicial finding that the committee acted independently and in good faith. To be sure, Judge Cardamone is correct in anticipating difficulties in judicial review of the recommendations of special litigation committees. These difficulties are not new, however, but have confronted every court which has scrutinized the fairness of corporate transactions involving a conflict of interest.

Moreover, the difficulties courts face in evaluation of business decisions are considerably less in the case of recommendations of special litigation committees. The relevant decision-whether to continue litigation-is at hand and the danger of deceptive hindsight simply does not exist. Moreover, it can hardly be argued that terminating a lawsuit is an area in which courts have no special aptitude. The rule we predict Connecticut would establish emphasizes matters such as probable liability and extent of recovery. For these reasons we hold that the wide discretion afforded directors under the business judgment rule does not apply when a special litigation committee recommends dismissal of a suit.

We think Connecticut would reject appellees' argument for a second reason. Limiting judicial scrutiny in cases such as the one before us to the good faith, thoroughness and independence of the special litigation committee would effectively eliminate the fiduciary obligation of directors and officers. As adumbrated further below, the present action involves classic allegations and substantial evidence of mismanagement and perhaps deliberate wrongdoing resulting in a loss exceeding 10% of the shareholders' capital and equity. The traditional fiduciary obligations of directors and officers under Connecticut law can hardly be said to exist if the sole enforcement method can be eliminated on a recommendation of the defendants' appointees.

We are aware that Auerbach v. Bennett, 47 N.Y.2d 619, 419 N.Y.S.2d 920, 393 N.E.2d 994 (1979), held that the business judgment rule limits judicial scrutiny of the recommendations of special litigation committees to their good faith, thoroughness and independence. Because we believe that test would work a major transformation of Connecticut corporate law, we predict that Connecticut would not adopt it.

We turn now to the contents of the Special Litigation Committee's Report. We emphasize that this recitation is the Committee's version of the facts. The record suggests that a trial might reveal sharply differing versions of the same events from various witnesses as well as sharply differing inferences drawn from that testimony.

According to the Report, Nelson L. North was Citytrust's Chief Executive Officer and Norman Schaff, Jr. was its Chief Lending Officer during the period in question. The management of Citytrust was completely dominated by North. Bank officers who did not temper themselves to his regime had a short tenure at the bank. North also exercised strong control over the activities of the Board of Directors. Board members were given neither materials nor agendas prior to meetings and requests for long range planning documents were left unanswered. North's control is illustrated by the fact that contrary to the recommendation of Citytrust's outside auditors, the bank's Audit Committee was not composed solely of outside directors but instead counted among its members Mr. North and one other officer. Minutes of the Audit Committee between 1971 and 1974 are largely incomplete. #p#分页标题#e#

Mr. North apparently brought the initial proposal for the Katz loan to Citytrust. From 1971 to 1976, North's son was employed by Katz, and he apparently deemed this a sufficient conflict of interest to preclude his voting on the Katz transactions in Executive Committee meetings. This fastidiousness appears to have been limited to the formality of voting, for the Report strongly suggests that North was deeply involved in the Katz transactions, although the full degree of his involvement is left uncertain. The Report also adds that Mr. North has destroyed his records.

Katz appears to have been experiencing financial difficulties as early as 1971. Chase Manhattan in fact opposed financing the Katz building in part because of a $1.6 *895 million shortfall between the building cost and available lending; it was North who persuaded Chase to make the initial mortgage loan. By 1972, Katz was falling behind in its loans and by December of that year owed Citytrust $990,000 with respect to the building. The Report concludes that by then Citytrust was effectively a joint venturer with Katz in the building, sharing the risk of loss but entitled at best only to interest and principal if things went well. There is also some indication that a portion of the unsecured advance made by Citytrust was being applied to the Chase mortgage.

Notwithstanding the increasingly evident peril in Citytrust's transactions with Katz, no appraisals of the buildings were undertaken until 1976, and no rentability study until 1974. Although Katz had suggested that a public offering would alleviate the situation, no professional review of the preliminary prospectus was undertaken. From 1972 through 1973, only one meeting of the Board of Directors or Executive Committee considered the Katz loans. The Senior Loan Committee did meet on the Katz matter late in 1972 and may have adopted a very cautious attitude toward further credit extension. Despite this, and despite the absence of Executive Committee and Board support, senior management extended almost a million dollars in loans to Katz between 1972 and 1973.
From 1973 through 1974, the number of Board meetings at which the Katz loans were considered increased to five. This is roughly contemporaneous with the recommendation of the outside auditors that a 50% special fund be set up for the Katz loans and the National Bank Examiners' classification of the total outstanding Katz indebtedness as substandard. It is, as the Report notes, “unsettling” that neither Schaff nor Citytrust's Comptroller recall being advised of the recommendation as to the special reserve. Moreover, it is not established that the Directors were advised of this recommendation.

By late 1974, the Katz loans were so clearly a problem that they were extensively considered by the Board and the Executive Committee. In fact, the Report notes that these loans were discussed at a minimum of 25 Board and Executive Committee meetings. Nevertheless, when, on August 18, 1976, the Board was presented with the request to go over the 10% limit, there was no prior mention of the issue on the agenda nor was opinion of counsel presented to the Board or even sought. Indeed, copies of the Comptroller's letter suggesting that Directors might wish to consult their personal counsel were not distributed to the Board. #p#分页标题#e#

The Report estimates a loss of $5.1 million to Citytrust. As stated earlier, there is an indication in the record that since the Report was issued, the new owner has defaulted and Citytrust again owns the building. If so, $5.1 million may be considerably less than the actual loss. In any event, a loss exceeding 10% of shareholder equity seems quite likely.

The Report contains the opinion of two experts. One concluded that the impact on morale of bank personnel, on the image of Citytrust among the banking public, upon persons who might be asked to become directors and upon potential new customers would offset even a recovery of $5.5 million.FN12 The other reached a different conclusion, stating that a recovery of even $2 million would be worth pursuing notwithstanding speculation about the public impact. It stated that this opinion would stand whether or not the outside directors continue as defendants, “as long as the insurance carrier is obligated through the ‘D and O policy’.” This last phrase might have given the Committee some pause since the letter requesting the opinion indicated that the insurance carrier had raised a question as to its liability.

As to the claims of breach of fiduciary duty, the Committee recommended that the suit be discontinued as to the outside defendants because there is “no reasonable possibility” that they might be found liable. As to the others, it concluded merely that

there is a possibility that a finding of negligence could be rendered against any one or more of the senior loan officers who participated in the Katz Corporation loans. Although it is emphasized that there is no evidence whatsoever of any self-dealing or of any deliberate impropriety, there is some indication that the most prudent lending principles were not adhered to during the evolution of those loans.

Applying the standard of review set out above to the Committee's recommendation, we look first to potential liability generally without regard to which defendants are responsible. As to that liability, we find that plaintiff's chances of success are rather high. The loss to Citytrust resulted from decisions which put the bank in a classic “no win” situation. The Katz venture was risky and increasingly so. By continuing extensions of substantial amounts of credit the bank subjected the principal to those risks although its potential gain was no more than the interest it could have earned in less risky, more diversified loans. In a real sense, there was a low ceiling on profits but only a distant floor for losses. It is so similar to the classic case of Litwin v. Allen, supra (bank purchase of bonds with an option in the seller to repurchase at the original price, the bank thus bearing the entire risk of a drop in price with no hope of gain beyond the stipulated interest) that we cannot agree with the Committee's conclusion that only a “possibility of a finding of negligence” exists.

The issue as to which defendants are responsible is less clear. The Committee concluded that there is “no reasonable possibility” of the outside defendants being found liable because they had neither information nor reasonable notice of the problems raised by the Katz transactions. We note first that members of the inside defendants may contradict that version and, if so, a possibility of liability in the outside group exists. Moreover, lack of knowledge is not necessarily a defense, if it is the result of an abdication of directional responsibility. McDonnell, supra; Atherton, supra. Directors who willingly allow others to make major decisions affecting the future of the corporation wholly without supervision or oversight may not defend on their lack of knowledge, for that ignorance itself is a breach of fiduciary duty. The issue turns in large part upon how and why these defendants were left in the dark. See Graham v. Allis Chalmers Mfg. Co., 41 Del.Ch. 78, 188 A.2d 125 (1963). An individual analysis of each outside defendant's role may show that some are blameless or even that they all were justified in not acting before they did, but neither is an inexorable conclusion on the basis of the present record. #p#分页标题#e#

The Report concluded as to the inside defendants that there was a “possibility” of liability. This conclusion is a considerable understatement and not entirely consistent with the Report's finding as to the outside defendants. The outsiders' best defense may well be that the inside group actively concealed the Katz problem. Given the fact that exoneration of the outside defendants may show culpability of the insiders and our conclusion that the probability of liability somewhere is high, we think the exposure of the inside group is considerably more than a “possibility.” Nor do we agree that “there is no evidence whatsoever” of deliberate impropriety. Not only is there the problem of North's apparently inconsistent behavior with respect to the appropriateness*897 of his participation in the considerations of Katz transactions, but his failure to keep the Board of Directors informed may well entail more than a negligent omission.

A precise estimate of potential damages is not possible since the trier must determine at what point liability begins. We think, however, that on the present record, a trier might easily find liability extending back to early 1972 or before (assuming no statute of limitations problem), resulting in a return of several million dollars to Citytrust, or perhaps 10% or more of the shareholder equity. This far exceeds the potential cost of the litigation to the corporation.

CONCLUSION
Applying the analysis described above, we conclude that the probability of a substantial net return to the corporation is high. We reject, therefore, the recommendation of the Special Litigation Committee. The grant of summary judgment is reversed, the protective order is vacated, and the case is remanded.