Delaware Offers Guidance on Special Litigation Committee Process

Theodore Mirvis is a partner in the Litigation Department at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton firm memorandum by Mr. Mirvis, William Savitt and Ryan A. McLeod, and relates to the decision in London v. Tyrrell, which is available here. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

A recent decision from the Delaware Court of Chancery confirms that Special Litigation Committees (SLCs) can be an effective means of responding to derivative litigation— but only when carefully structured and properly implemented. London v. Tyrrell, C.A. No. 3321-CC (Del. Ch. Mar. 11, 2010).

The decision arose in a suit by the founders and former directors of iGov, alleging that company insiders had intentionally manipulated the valuation process used to set the strike price of certain options for the purpose of entrenching themselves and diluting plaintiffs’ interest in the company. In 2008, after the Court concluded that demand on the board was excused and refused to dismiss the complaint, the board formed an SLC comprised of directors appointed after the filing of the lawsuit to evaluate whether the derivative claims should be pursued on behalf of the company. The SLC retained advisors, reviewed documents, and conducted twelve interviews over the course of four months, and then filed a report recommending dismissal.

Under the familiar Zapata test, the SLC must show that it was independent and that the scope of its investigation was reasonable before the Court will even consider the substantive soundness of an SLC’s recommendation. The SLC here was found to have failed on both counts.

As to independence, the Court stressed that the SLC must carry the burden of “fully convinc[ing] the Court that the SLC can act with integrity and objectivity.” Here, one committee member was the husband of the defendant’s cousin, and the other was a former colleague of the defendant who felt indebted to the defendant for getting him “a good price” in the prior sale of a company. The Court ruled that “it will be nigh unto impossible” to show independence where “the SLC member and a director defendant have a family relationship” or where an SLC member “feels he owes something to an interested director.” The Court was further troubled by deposition testimony and notes suggesting that the SLC members viewed their job as “attacking” the plaintiffs’ complaint.

As to the SLC’s investigation, the Court found that the committee wrongly concluded that claims to rescind the options were barred by the exculpation provision in iGov’s charter, made key mistakes of fact, and systematically failed to pursue evidence that might suggest liability. The Court’s bottom line was that an SLC must provide a reasonable record to show that it has fairly evaluated the facts and legal claims that a derivative plaintiff raises, and that an insufficiently vigorous process will not be accorded judicial deference.

As the Chancellor took pains to note, the SLC process remains “a legitimate mechanism in [Delaware] corporate law,” and in an appropriate case it can serve the corporate interest by short-circuiting ill-advised litigation and restoring the board’s prerogative of setting corporate litigation policy. But the London decision serves as a warning that if not implemented with reflection and executed with care, the SLC device can do more harm than good.

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