This essay focuses on the classic 1940 case Litwin v. Allen, 25 N.Y.S.2d 667 (N.Y. Sup. Ct. 1940), in which the court ruled that directors and officers of a bank were liable for losses suffered by the bank from a transaction in which the bank bought a bond at a discounted price subject to an option permitting the seller to buy it back at the same price (up to) six months later. The price of the bond fell dramatically during the option period, the seller declined to buy it back, and the bank was left with the loss. The court ruled that the defendant directors and officers were not protected by the business judgment rule—which precludes liability for losses from good faith business decisions—because the deal entailed assuming an extra risk of loss without the prospect of extra return. In effect, it was a no-win bet in which the bank would break even at best. Thus, Litwin articulates one way that corporate management (and indeed any fiduciary) can be held accountable for losses suffered by the corporation (or principal) other than because of a disabling conflict of interest. Although the Litwin court states the rule correctly, it is wrong on the facts. What the court fails to see is that the bank did bargain for extra return because it bought the bond at a discount from market value. Moreover, the bank could have hedged against the risk of loss and may indeed have been hedged by virtue of diversification. But to understand why the result in Litwin is wrong, one must understand the fundamentals of time value of money, going concern value, option pricing, portfolio
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