On certification to the Superior Court, Appellate Division.
(This syllabus is not part of the opinion of the Court. It has been prepared by the Office of the Clerk for the convenience of the reader. It has been neither reviewed nor approved by the Supreme Court. Please note that, in the interests of brevity, portions of any opinion may not have been summarized).
In this appeal, the Court considers the proper standard of review to be applied in evaluating whether a corporation's board of directors responded properly in rejecting a shareholder's demand to commence legal action on the corporation's behalf, and whether the lower court correctly applied that standard in this case.
This appeal stems from four derivative actions brought by shareholders of Public Service Enterprise Group, Incorporation (Enterprise), a public utility holding company, and its wholly-owned subsidiary, Public Service Electric & Gas Company (PSE&G)(collectively, the company). Defendants are certain directors of both entities and include current and former PSE&G officers (collectively, the Board). PSE&G operates the Salem and Hope Creek nuclear power plants (power plants) located in southern New Jersey. Based on events that took place over a period of many years, plaintiffs allege that defendants recklessly mismanaged both power plants to the company's financial detriment.
On October 4, 1995, following the closing of one of the power plants, plaintiff G.E. Stricklin sent a formal demand letter to the Board asking it to institute suit against each of its officers for mismanagement of the nuclear operations. In response, the Board adopted a resolution on October 17, 1995, retaining the law firm of Kasowitz, Benson,Torres & Friedman (the Kasowitz firm) to investigate the allegations raised in the demand letter. On December 27, 1995, before the Kasowitz firm's investigation was complete, Stricklin filed a shareholder derivative complaint that raised the same allegations as the demand letter and contended that Board members should be held personally liable for the company's financial losses. Stricklin also contended that her demand on the Board had been rejected wrongfully because the Board had not acted on it. On February 28 and March 5, 1996, additional shareholders filed two more derivative actions, but they did not make a demand on the company prior to instituting suit. Instead, they assert that such demand would have been futile.
Meanwhile, the Kasowitz firm reviewed over 43,000 pages of documents and conducted over thirty interviews with company personnel. After completing its investigation, the firm issued a 124-page report on February 8, 1996, and a supplemental report on March 14, 1996, concluding that there was no basis on which to institute legal action against any employee, officer, or director of Enterprise or PSE&G. On March 19, 1996, the Board adopted a resolution accepting the Kasowitz firm's recommendations. Later, in depositions or certifications, the Board members gave their reasons for rejecting the litigation, including 1) the memorandum and reports presented by counsel; 2) the inquisitiveness and preparedness of Board members at meetings during the relevant time period; 3) the open lines of communication and information in respect of the company's nuclear operations; 4) the depth of the information presented to the Board on a regular basis and its vigorous action in response to that information; and 5) the excessive cost of such litigation.
On July 3, 1996, a fourth shareholder filed a complaint. The trial court consolidated the four actions and defendants moved to dismiss the complaints. In December 1996, the trial court found that all four plaintiffs had alleged sufficient facts to withstand dismissal. The trial court further excused the failure to make a demand by some of the plaintiffs because it found that they had alleged sufficient facts to create a reasonable doubt that the directors were disinterested or independent. The Appellate Division and this Court denied leave to appeal.
After the consolidated cases were transferred to another judge, the cases were bifurcated according to whether a demand had been made by the plaintiffs (demand-made cases), or whether a demand had not been made by the plaintiffs (demand-futile cases). Defendants moved for summary judgment in the demand-made cases in December
1997 and in the demand-futile actions in May 1998. In deciding the motions, the judge adopted a modified version of the business judgment rule and ordered discovery on issues that included the disinterestedness of the Board and the reasonableness of its decision to terminate litigation. The trial court granted defendants' motions for summary judgment at the conclusion of discovery. The Appellate Division affirmed.
HELD: The Court adopts the modified business judgment rule as the standard for evaluating whether a corporation's board of directors responded properly in rejecting a shareholder's demand or in deciding to terminate legal action on the corporation's behalf. The modified business judgment rule places an initial burden on directors to demonstrate that they acted reasonably, in good faith, and in a disinterested fashion in arriving at their decision. The lower courts properly applied that standard when dismissing the derivative litigation in this case.
1. A shareholder derivative action permits a shareholder to bring suit on behalf of the corporation and, if successful, it forces the wrongdoers to compensate the corporation for the injury they caused. Shareholder derivative litigation is an infringement on director autonomy and may have a negative effect on corporate governance if, for example, it is initiated by opportunistic shareholders. Therefore, as a prerequisite to derivative litigation, most jurisdictions require that shareholders make a demand on the corporation's board of directors to act. New Jersey's procedure is codified under Rule 4:32-5. Like most jurisdictions, New Jersey will excuse the demand requirement if the shareholder can establish that it would be futile. For shareholder plaintiffs in New Jersey to withstand a motion to dismiss for failure to make a demand, they must plead with particularity facts creating a reasonable doubt that: 1) the directors are disinterested and independent; or 2) the challenged transaction was the product of a valid exercise of business judgment. (Pp. 18 to 29).
2. The Court agrees with those jurisdictions that apply a single standard of review in both demand-made case and in cases in which the demand was excused, and adopts a modified business judgment rule that imposes an initial burden on a corporation to demonstrate that in deciding to reject or terminate a shareholder's suit the members of the board 1) were independent and disinterested; 2) acted in good faith and with due care in their investigation of the shareholder's allegations, and that 3) the board's decision was reasonable. Shareholders must be permitted access to corporate documents and other discovery limited to the narrow issue of what steps the directors took to inform themselves of the shareholder demand and the reasonableness of their decision. (Pp. 29 to 33).
3. The main difference between the test for determining demand-futility and the modified business judgment rule is that a plaintiff has the burden of demonstrating demand-futility, whereas a defendant has the burden of satisfying the elements of the modified business judgment rule. If the court relieves a shareholder of the demand requirement, a defendant may later renew its motion to dismiss the litigation. At that juncture, the court would evaluate the motion by applying the burden-shifting and other aspects of the modified business judgment rule. Although the demand- futility test and the modified business judgment rule both implicate whether directors are disinterested and independent, a court applying the modified business judgment rule is not bound by any finding associated with an earlier court's decision to excuse demand. The court should consider the board's decision under the modified business judgment rule only after the parties have completed adequate discovery to enable the court to render a fully-informed decision. (Pp. 33 to 37).
4. The thrust of plaintiffs' allegations is that defendants mismanaged the company and breached their duty of care. The Court reserves for another day what the appropriate standard might be for allegations such as self-dealing, fraud, or similar bad acts. (Pp. 37 to 38).
5. The Court finds that defendants presented undisputed evidence proving that they were disinterested and independent when they decided to reject the demand and terminate the litigation. Moreover, nothing in the record demonstrated that the directors had divided loyalties, stood to receive any improper personal gain or were unduly influenced by any improper motive. Therefore, defendants satisfied the first element of the modified business judgment rule. (Pp. 38 to 41).
6. The second element of the modified business judgment rule, whether defendants acted in good faith and with due care in investigating the merits of the litigation, was met through the extensive investigation and resulting report by the Kasowitz firm, which was experienced in nuclear power matters and in shareholder litigation. (Pp. 41 to 46).
7. Finally, defendants satisfied the final element of the test by demonstrating that their decision to terminate the litigation was reasonable. By virtue of the procedures that they employed, defendants informed themselves of the substance of the shareholders' allegations and weighed those allegations against the likelihood that the litigation would succeed. The Board acted consistent with the principles articulated in the Court's opinion when relying on the Kasowitz investigation to guide its decision. (Pp. 47 to 51).
The judgment of the Appellate Division is AFFIRMED.
JUSTICE STEIN, concurring in the Court's opinion, agrees that the Board satisfied the legal standard for independence in this matter, but emphasizes that the de novo review undertaken by trial and appellate courts should include a scrupulous and painstaking examination of the record to ensure that the board's discretion has been exercised reasonably and responsibly. Further, Justice Stein is of the view that the Kasowitz firm's dual role as the Board's independent investigator and its brief role as the Board's litigation counsel was inappropriate, but he believes that the dual role did not render unreasonable the Board's reliance on the investigative report.
CHIEF JUSTICE PORITZ and JUSTICES COLEMAN, LONG, and LaVECCHIA join in JUSTICE VERNIERO's opinion. JUSTICE STEIN filed a separate concurring opinion. JUSTICE ZAZZALI did not participate.
The opinion of the court was delivered by: Verniero, J.
We are called on to address certain questions of first impression regarding the law of business organizations in New Jersey. The principal issue concerns the proper standard of review to be applied when evaluating whether a corporation's board of directors has responded properly in rejecting a shareholder's demand to commence legal action on the corporation's behalf. We hold that a modified version of the business judgment rule is the appropriate legal standard in such circumstances. Unlike the traditional approach, the modified business judgment rule places an initial burden on directors to demonstrate that they acted reasonably, in good faith, and in a disinterested fashion in arriving at their decision to reject a shareholder's demand or to terminate existing litigation. We further hold that the lower courts correctly applied that standard when dismissing the derivative litigation in this case.
This appeal stems from four derivative actions brought by shareholders of Public Service Enterprise Group, Incorporated (Enterprise), a public utility holding company, and its wholly- owned subsidiary, Public Service Electric & Gas Company (PSE&G) (collectively, the company). Defendants are certain directors of both entities, and include current and former PSE&G officers. (For convenience, we do not distinguish between members of the Enterprise and PSE&G boards; unless otherwise indicated, we refer to them collectively as the Board.)
PSE&G operates the Salem and Hope Creek nuclear power plants located in southern New Jersey. During the relevant period, a series of malfunctions and safety violations plagued the Salem plant, causing federal regulators to assess significant fines against the company. Hope Creek also experienced problems, but not as frequently as those that had occurred at Salem. In a nutshell, plaintiffs allege that defendants recklessly mismanaged both facilities to the company's financial detriment.
We recount the most noteworthy events. In February 1983, the Salem plant's reactor protection systems failed to operate automatically, requiring employees to shut down the reactors manually. Later, in November 1991, one of the turbines at the Salem plant exceeded its normal speed, causing parts of several blades to fly off its shaft. In December 1992, nuclear department managers were accused of harassing two engineers who tried to file an incident report in response to a safety concern at the plant. In that same month, an employee inadvertently turned off the plant's overhead annunciator system, which alerts plant employees to alarm conditions. That misstep went undetected by management and operations personnel for ninety minutes.
In 1993, management and equipment failures continued to plague the Salem facility. In June of that year, PSE&G shut down Salem unit two due to a failure in the rod control system. One year later, PSE&G shut down Salem unit one and declared an alert when marsh grass clogged that unit's water coolant system. In 1995, PSE&G shut down both Salem units because of a failure of two different pieces of equipment.
In 1995, problems also arose at the Hope Creek plant. In April, a release of radioactive material occurred during maintenance operations. Three months later, a planned shutdown went awry when the plant's operators left a discharge valve open, causing an increase in the reactor coolant temperature.
The United States Nuclear Regulatory Commission (NRC) took action in response to each event at the Salem and Hope Creek facilities. After the 1983 shutdown, the NRC revised the Salem license, requiring remedial actions to assure the safe operation of the plant. Following each of the 1991, 1992, and 1993 incidents, the NRC sent a special team to conduct immediate safety inspections of the Salem plant. Due to the severity of Salem's 1995 malfunctions, the NRC prohibited PSE&G from re- starting either unit at Salem without the agency's prior approval. The NRC placed the plant on the agency's "watch list" in 1997.
In January 1995, the NRC issued its Systematic Assessment of Licensee Performance (SALP) rating of the Salem plant for the period June 20, 1993, to November 5, 1994. The NRC gave the Salem plant a "3" rating, the lowest possible score, in the Operations and Maintenance categories. That resulted in a 2.25 overall rating for the plant, placing it in the bottom quartile nationally. In March 1995, representatives of the NRC, including its executive director of operations, met with members of the Board in response to those SALP ratings. One Board member explained that a meeting of that nature was a "rare event." By the end of 1995, the NRC had assessed over $2 million in fines against PSE&G in response to the ongoing violations at the Salem and Hope Creek facilities. The SALP rating of the Hope Creek Plant also was lowered. Finally, another nuclear-utility oversight organization, the Institute of Nuclear Power Operations (INPO), issued poor ratings for both the Salem and Hope Creek plants.
In response to the Salem and Hope Creek events, the Board took steps to gather information regarding the shortcomings of the facilities and the concerns raised by the NRC and INPO. Following the 1983 incident at the Salem plant, the Board created the Nuclear Oversight Committee (NOC) that was comprised of a Board liaison and outside experts in the nuclear energy field. The NOC was charged with receiving information regarding PSE&G's operations, preparing reports for the Board, and making recommendations based on that information. In 1995, the Board replaced the NOC, reconstituting it as a committee of the Enterprise board.
In 1994, PSE&G created its own Nuclear Review Board (NRB). Similar to the former NOC, the NRB is comprised of outside experts in the nuclear field and PSE&G senior nuclear personnel.
The NRB's function is to review the nuclear operations of PSE&G and to provide counsel to both PSE&G's chief nuclear officer and the Enterprise board regarding the company's nuclear safety and operational performance. From 1983 to 1997, the Board also received information regarding nuclear operations from PSE&G's senior officers and other senior management personnel. Representatives of both the NRC and INPO attended Board meetings and advised that group directly regarding nuclear operations.
In 1989, the Board instituted a revitalization program at the Salem plant, in respect of which the company spent $300 million to upgrade equipment and facilities. The Board also intended the program to improve procedures and personnel. Those actions resulted in a favorable review by the NRC for the 1991- 1993 period, although the agency noted that the company was slow in responding to some concerns. In 1994, after receiving an internal report that acknowledged the need to "change the culture" at Salem, the Board replaced its chief nuclear officer. However, as evidenced by declining SALP ratings and the subsequent 1995 closure of the Salem plant, those changes had limited effectiveness.
On October 4, 1995, following the closing of the Salem units, plaintiff G.E. Stricklin sent a demand letter to the Board asking it to institute suit against "each of its officers" for alleged mismanagement of the company's nuclear operations. Stricklin claimed that the Board's failure to take prompt action to correct the problems at the Salem and Hope Creek plants resulted in millions of dollars of damages to the company, only a portion of which could be recovered from ratepayers. Stricklin also alleged that members of the Board purposely had failed to disclose PSE&G's difficulties in a timely manner to ensure their re-election to the Board itself. Although she believed the demand effort to be futile, Stricklin designed her letter "to satisfy any conceivable requirement that a formal demand be made prior to the commencement of derivative litigation."
In response to Stricklin's letter, the Board adopted a resolution on October 17, 1995, retaining the law firm of Kasowitz, Benson, Torres & Friedman (the Kasowitz firm). The Board directed the firm to investigate the allegations raised in the demand letter.
On December 27, 1995, before the Kasowitz firm had completed its work, Stricklin filed a shareholder derivative complaint against defendants in the Superior Court, Law Division in Camden County. The complaint raises substantially the same allegations as the demand letter, and contends that Board members should be held personally liable for the company's financial losses. Plaintiff also asserts that her earlier demand on the Board had been rejected wrongfully because at the time of her complaint the Board had not acted in response to her demand.
On February 13, 1996, the parties entered into a stipulation to extend time to answer or otherwise respond to the complaint so that the Board could complete its investigation. Shortly before that date, on February 8, 1996, the Kasowitz firm issued a 124-page report regarding its investigation of Stricklin's demand. The firm focused its report on the period following January 1, 1993, because, among other reasons, Stricklin did not own stock in the company prior to that date.
The firm reviewed over 43,000 pages of documents, including Board minutes, internal reports, and documents generated by the NRC and other agencies. The firm also conducted over thirty interviews with Enterprise and PSE&G personnel. The firm did not interview plaintiff's representatives because they had refused the firm's request for a meeting. Based on its review, the Kasowitz firm concluded that there was no basis for Enterprise to institute legal action against any employee, officer, or director of Enterprise or PSE&G in respect of the Salem and Hope Creek facilities.
More specifically, the report concluded that the Board had attempted, in a diligent and good-faith manner, to address the issues at both the Salem and Hope Creek sites and to discover and remedy deficiencies in equipment and management. The report further determined that the Board had established an information network that ensured that the material issues that arose in the facilities were brought to the Board's attention promptly and completely. The report cited the NOC and its successor committee as the primary conduits for that information. The report also found that the Board was informed sufficiently by independent nuclear experts.
The report addressed the steps that the Board had taken in response to the problems at the facilities. The report noted that the Board had changed reporting structures and created a new nuclear business unit to establish a greater familiarity with the company's nuclear business. Further, the report detailed the personnel changes made by the Board to improve the culture and management at the facilities. Finally, the report described ...