Gagliardi v. Trifoods International, Inc.

683 A.2d 1049 (Del. Ch. 1996)

ALLEN, Chancellor.

Currently before the Court is a motion to dismiss a shareholders action against the directors of TriFoods

International, Inc. and certain partnerships and individuals that own stock in TriFoods. In broadest terms

the motion raises the question, what must a shareholder plead in order to state a derivative claim to recover

corporate losses allegedly sustained by reason of "mismanagement" unaffected by directly conflicting

financial interests?

Plaintiff, Eugene Gagliardi, is the founder of the TriFoods, Inc. and in 1990 he induced certain persons

to invest in the company by buying its stock. In 1993 he was removed as Chairman of the board and his

employment with the company terminated. He continues to own approximately 13% of the company's

common stock. The business of the company has, according to the allegations of the complaint, deteriorated

very badly since Mr. Gagliardi's ouster.

The suit asserts that defendants are liable to the corporation and to plaintiff individually on a host of

theories, most importantly for mismanagement. . . .

COUNT IV: NEGLIGENT MISMANAGEMENT

This count, which is asserted against all defendants, alleges that "implementation of their grandiose

scheme for TriFoods' future growth . . . in only eighteen months destroyed TriFoods." Plaintiff asserts that

the facts alleged, which sketch that "scheme" and those results, constitute mismanagement and waste.

The allegations of Count IV are detailed. They assert most centrally that prior to his dismissal Gagliardi

disagreed with Hart [TriFoods' former president] concerning the wisdom of TriFoods manufacturing its

products itself and disagreed strongly that the company should buy a plant in Pomfret, Connecticut and

move its operations to that state. Plaintiff thought it foolish (and he alleges that it was negligent judgment)

to borrow funds . . . for that purpose.

Plaintiff also allegesthat Hart caused the company to acquire and fit-out a research or new product facility

in Chadds Ford, Pennsylvania, which "duplicated one already available and under lease to Designer Foods

[the predecessor name of TriFoods], and which was therefore, a further waste of corporate assets."

Next, it is alleged that "defendants either acquiesced in or approved a reckless or grossly negligent sales

commission to build volume."

Next, it is alleged that "Hart and the other defendants caused TriFoods to purchase [the exclusive rights

to produce and sell a food product known as] Steak-umms from Heinz in April 1994." The price paid

compared unfavorably with a transaction in 1980 in which this product had been sold and which earlier

terms are detailed. "Defendants recklessly caused TriFoods to pay $15 million for Steak-umms alone (no

plant, no equipment, etc) which was then doing annual sales of only $28 million."

Next, it is alleged that "Hart caused TriFoods . . . to pay $125,000 to a consultant for its new name, logo

and packaging."

Next, it is alleged that Hart destroyed customer relationships by supplying inferior products.

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Next, it is alleged that "Hart refused to pay key manufacturers and suppliers . . . thus injuring TriFoods'

trade relations."

Next, it is alleged that "defendants entered into a transaction whereby TriFoods was to acquire "Lloyd's

Ribs" at a grossly excessive price, knowing (or recklessly not knowing) that the Company could not afford

the transaction." . . .

Do these allegations of Count IV state a claim upon which relief may be granted? In addressing that

question, I start with what I take to be an elementary precept of corporation law: in the absence of facts

showing self-dealing or improper motive, a corporate officer or director is not legally responsible to the

corporation for losses that may be suffered as a result of a decision that an officer made or that directors

authorized in good faith. There is a theoretical exception to this general statement that holds that some

decisions may be so "egregious" that liability for losses they cause may follow even in the absence of proof

of conflict of interest or improper motivation. The exception, however, has resulted in no awards of money

judgments against corporate officers or directors in this jurisdiction and, to my knowledge only the dubious

holding in this Court of Gimbel v. Signal Companies, Inc., (Del. Ch.) 316 A.2d 599 aff'd (Del. Supr.) 316

A.2d 619 (1974), seems to grant equitable relief in the absence of a claimed conflict or improper motivation.

Thus, to allege that a corporation has suffered a loss as a result of a lawful transaction, within the

corporation's powers, authorized by a corporate fiduciary acting in a good faith pursuit of corporate

purposes, does not state a claim for relief against that fiduciary no matter how foolish the investment may

appear in retrospect.

The rule could rationally be no different. Shareholders can diversify the risks of their corporate

investments. Thus, it is in their economic interest for the corporation to accept in rank order all positive net

present value investment projects available to the corporation, starting with the highest risk adjusted rate

of return first. Shareholders don't want (or shouldn't rationally want) directors to be risk averse.

Shareholders' investment interests, across the full range of their diversifiable equity investments, will be

maximized if corporate directors and managers honestly assess risk and reward and accept for the

corporation the highest risk adjusted returns available that are above the firm's cost of capital.

But directors will tend to deviate from this rational acceptance of corporate risk if in authorizing the

corporation to undertake a risky investment, the directors must assume some degree of personal risk relating

to ex post facto claims of derivative liability for any resulting corporate loss.

Corporate directors of public companies typically have a very small proportionate ownership interest in

their corporations and little or no incentive compensation. Thus, they enjoy (as residual owners) only a very

small proportion of any "upside" gains earned by the corporation on risky investment projects. If, however,

corporate directors were to be found liable for a corporate loss from a risky project on the ground that the

investment was too risky (foolishly risky! stupidly risky! egregiously risky! you supply the adverb), their

liability would be joint and several for the whole loss (with I suppose a right of contribution). Given the scale

of operation of modern public corporations, thisstupefying disjunction between risk and reward for corporate

directors threatens undesirable effects. Given this disjunction, only a very small probability of director

liability based on "negligence," "inattention," "waste," etc., could induce a board to avoid authorizing risky

investment projects to any extent! Obviously, it is in the shareholders' economic interest to offer sufficient

protection to directors from liability for negligence, etc., to allow directors to conclude that, as a practical

matter, there is no risk that, if they act in good faith and meet minimal proceduralist standards of attention,

they can face liability as a result of a business loss.

The law protects shareholder investment interests against the uneconomic consequences that the

presence of such second-guessing risk would have on director action and shareholder wealth in a number

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of ways. It authorizes corporations to pay for director and officer liability insurance and authorizes

corporate indemnification in a broad range of cases, for example. But the first protection against a threat of

sub-optimal risk acceptance is the so-called business judgment rule. That "rule" in effect provides that

where a director is independent and disinterested, there can be no liability for corporate loss, unless the

facts are such that no person could possibly authorize such a transaction if he or she were attempting in

good faith to meet their duty. Saxe v. Brady, Del. Ch., 184 A.2d 602 (1962).

Thus, for example it does not state a claim to allege that: (1) Hart caused the corporation to pay $125,000

to a consultant for the design of a new logo and packaging. On what possible basis might a corporate officer

or director be put to the expense of defending such a claim? Nothing is alleged except that an expenditure

of corporate funds for a corporate purpose was made. Whether that expenditure was wise or foolish, low

risk or high risk is of no concern to this Court. What is alleged certainly does not bring the allegation to

within shouting distance of the Saxe v. Brady principle. (2) Nor does an allegation that defendants

acquiesced in a reckless commission structure "in order to build volume" state a claim; it alleges no

conflicting interest or improper motivation, nor does it state facts that might come within the Saxe v. Brady

principle. It alleges only an ordinary business decision with a pejorative characterization added. (3) The

allegation of "duplication" of existing product research facilities similarly simply states a matter that falls

within ordinary business judgment; that plaintiff regards the decision as unwise, foolish, or even stupid in

the circumstances is not legally significant; indeed that others may look back on it and agree that it was

stupid is legally unimportant, in my opinion. (4) That the terms of the purchase of "Steak-umms" seem to

plaintiff unwise (especially when compared to the terms of a 1980 transaction involving that product) again

fail utterly to state any legal claim. No self-interest, nor facts possibly disclosing improper motive or

judgment satisfying the waste standard are alleged. Similarly, (5) the allegations of corporate loss resulting

from harm to customer relations by delivery of poor product and (6) harm to supplier relations by poor

payment practices, again state nothing that constitutes a legal claim. Certainly these allegations state facts

that, if true, constitute either mistakes, poor judgment, or reflect hard choices facing a cash-pressed

company, but where is the allegation of conflicting interest or suspect motivation? In the absence of such,

where are the facts that, giving the pleader all reasonable inferences in his favor, might possibly make the

Saxe v. Brady principle applicable? There are none. Nothing is alleged other than poor business practices.

To permit the possibility of director liability on that basis would be very destructive of shareholder welfare

in the long-term.

A similar analysis holds for the allegations concerning a contract to acquire the product "Lloyd's Ribs"

(7); nothing is alleged other than that the price was excessive and the directors knew (or recklessly didn't

know) that "the company could not afford such a transaction." . . .

For the foregoing reason Count IV of the amended complaint will be dismissed. .

Questions:

What bad business decisions did the defendants make? Why did the court nonetheless dismiss the case?

What is the business judgment rule? According to the court, what is the policy behind the rule?

What recourse does a shareholder who disagrees with a board decision have?

What do you think about the business judgment rule?